Against the Gods: The Remarkable Story of Risk (49 page)

The most authoritative statement on the subject of risk had been
issued in 1830 and had been purposefully vague.' It appeared in the
judge's decision in a lawsuit over the administration of the estate of
John McLean of Boston. McLean had died on October 23, 1823, leaving $50,000 in trust for his wife to receive the "profits and income
thereof' during her lifetime; on her death, the trustees were to distribute half the remainder to Harvard College and the other half, or "moiety," to Massachusetts General Hospital. When Mrs. McLean died in
1828, the estate was valued at only $29,450. Harvard and the hospital
promptly joined in bringing suit against the trustees.

In rendering his decision in the case, justice Samuel Putnam concluded that the trustees had conducted themselves "honestly and discreetly and carefully, according to the existing circumstances, in the
discharge of their trusts." He declared that trustees cannot be held
accountable for a loss of capital that was not "owing to their wilful
default.... If that were otherwise, who would undertake such hazardous responsibility?" He continued with what came to be immortalized
as the Prudent Man Rule:

Do what you will, the capital is at hazard.... All that can be required
of a trustee to invest, is, that he shall conduct himself faithfully and
exercise a sound discretion. He is to observe how men of prudence,
discretion, and intelligence manage their own affairs, not in regard to
speculation, but in regard to the permanent disposition of their funds,
considering the probable income, as well as the probable safety of the
capital to be invested.

There the matter rested for 122 years.

In June 1952, the Journal of Finance, the leading academic journal in
finance published a fourteen-page article titled "Portfolio Selection. "3 Its
author was Harry Markowitz, an unknown 25-year-old graduate student
at the University of Chicago. That paper was innovative on so many
levels, and ultimately so influential both theoretically and in terms of
practicality, that it earned Markowitz a Nobel Prize in Economic Science
in 1990.

In choosing equity investing as his topic, Markowitz was dealing with a subject that serious journals up to that time had considered too dicey and speculative for sober academic analysis. Even more daring, Markowitz was dealing with the management of the investor's total wealth, the portfolio.*
His main theme was that a portfolio of securities is entirely different from holdings considered individually.

He had no interest in the foolishness that characterized most stockmarket literature, such as lessons from a ballet dancer on how to become a millionaire without really trying, or how to be recognized as a guru among market forecasters.4 Nor did he make any effort to present his ideas in the simple-minded language typical of most articles about the stock market. At a time when any kind of mathematical treatment was rare in economics, particularly in and von Neumann had cut a lot less ice up to that point than they had hoped-ten of the fourteen pages that make up Markowitz's article carry equations or complicated graphs.

Markowitz is parsimonious in providing footnotes and bibliography: he makes only three references to other writers in a setting where many academics measured accomplishment by the number of footnotes an author could manage to compile. This failure to credit his intellectual forebears is curious: Markowitz's methodology is a synthesis of the ideas of Pascal, de Moivre, Bayes, Laplace, Gauss, Galton, Daniel Bernoulli, Jevons, and von Neumann and Morgenstern. It draws on probability theory, on sampling, on the bell curve and dispersion around the mean, on regression to the mean, and on utility theory. Markowitz has told me that he knew all these ideas but was not familiar with their authors, though he had invested a good deal of time studying von Neumann and Morgenstern's book on economic behavior and utility.

Markowitz placed himself solidly in the company of those who see human beings as rational decision-makers. His approach reflects the spirit of the early years after the Second World War, when many social scientists set about reviving the Victorian faith in measurement and the belief that the world's problems could be solved.

Strangely, Markowitz had no interest in equity investment when he
first turned his attention to the ideas dealt with in "Portfolio Selection."
He knew nothing about the stock market. A self-styled "nerd" as a student, he was working in what was then the relatively young field of linear
programming. Linear programming, which happened to be an innovation
to which John von Neumann had made significant contributions, is a
means of developing mathematical models for minimizing costs while
holding outputs constant, or for maximizing outputs while holding costs
constant. The technique is essential for dealing with problems like those
faced by an airline that aims to keep a limited number of aircraft as busy
as possible while flying to as many destinations as possible.

One day, while waiting to see his professor to discuss a topic for
his doctoral dissertation, Markowitz struck up a conversation with a
stock broker sharing the waiting room who urged him to apply linear
programming to the problems investors face in the stock market.
Markowitz's professor seconded the broker's suggestion, enthusiastically, though he himself knew so little about the stock market that he
could not advise Markowitz on how or where to begin the project. He
referred Markowitz to the dean of the business school, who, he hoped,
might know something about the subject.

The dean told Markowitz to read John Burr Williams' The Theory
of Investment Value, an influential book on finance and business management. Williams was a scrappy, impatient man who had launched a
successful career as a stock broker in the 1920s but had returned to
Harvard as a graduate student in 1932, at the age of thirty, hoping to
find out what had caused the Great Depression (he didn't). The Theory
of Investment Value, published in 1938, was his Ph.D. thesis.

Markowitz dutifully went to the library and sat down to read. The
book's very first sentence did the trick for him: "No buyer considers all
securities equally attractive at their present market prices ... on the
contrary, he seeks `the best at the price."'S Many years later, when
Markowitz was telling me about his reaction, he recalled, "I was struck
with the notion that you should be interested in risk as well as return."

That "notion" seems unremarkable enough in the 1990s, but it
attracted little interest in 1952, or, for that matter, for more than two
decades after Markowitz's article was published. In those days, judgments about the performance of a security were expressed in terms of
how much money the investor made or lost. Risk had nothing to do with it. Then, in the late 1960s, the aggressive, performance-oriented
managers of mutual fund portfolios began to be regarded as folk heroes,
people like Gerry Tsai of the Manhattan Fund ("What is the Chinaman
doing?" was a popular question along Wall Street) and John Hartwell
of the Hartwell & Campbell Growth Fund (" [Performance means]
seeking to get better than average results over a fairly long period of
time-consistently") .6

It took the crash of 1973-1974 to convince investors that these
miracle-workers were just high rollers in a bull market and that they too
should be interested in risk as well as return. While the Standard & Poor's
500 fell by 43% from December 1972 to September 1974, the Manhattan
Fund lost 60% and the Hartwell & Cambell Fund fell by 55%.

This was a dark time, one marked by a series of ominous events:
Watergate, skyrocketing oil prices, the emergence of persistent inflationary forces, the breakdown of the Bretton Woods Agreements, and an
assault on the dollar so fierce that its foreign exchange value fell by 50%.

The destruction of wealth in the bear markets of 1973-1974 was
awesome, even for investors who had thought they had been investing
conservatively. After adjustment for inflation, the loss in equity values
from peak to trough amounted to 50%, the worst performance in history other than the decline from 1929 to 1931. Worse, while bondholders in the 1930s actually gained in wealth, long-term Treasury
bonds lost 28% in price from 1972 to the bottom in 1974 while inflation.
was running at 11% a year.

The lessons learned from this debacle persuaded investors that "performance" is a chimera. The capital markets are not accommodating
machines that crank out wealth for everyone on demand. Except in
limited cases like holding a zero-coupon debt obligation or a fixed-rate
certificate of deposit, investors in stocks and bonds have no power over
the return they will earn. Even the rate on savings accounts is set at the
whim of the bank, which responds to the changing interest rates in the
markets themselves. Each investor's return depends on what other
investors will pay for assets at some point in the uncertain future, and
the behavior of countless other investors is something that no one can
control, or even reliably predict.

On the other hand, investors can manage the risks that they take.
Higher risk should in time produce more wealth, but only for investors
who can stand the heat. As these simple truths grew increasingly obvi ous over the course of the 1970s, Markowitz became a household name
among professional investors and their clients.

Markowitz's objective in "Portfolio Selection" was to use the notion
of risk to construct portfolios for investors who "consider expected return
a desirable thing and variance of return an undesirable thing. "7 The italicized "and" that links return and variance is the fulcrum on which
Markowitz builds his case.

Markowitz makes no mention of the word "risk" in describing his
investment strategy. He simply identifies variance of return as the
"undesirable thing" that investors try to minimize. Risk and variance
have become synonymous. Von Neumann and Morgenstern had put a
number on utility; Markowitz put a number on investment risk.

Variance is a statistical measurement of how widely the returns on
an asset swing around their average. The concept is mathematically
linked to the standard deviation; in fact, the two are essentially interchangeable. The greater the variance or the standard deviation around
the average, the less the average return will signify about what the outcome is likely to be. A high-variance situation lands you back in the
head-in-the-oven-feet-in-the-refrigerator syndrome.

Markowitz rejects Williams' premise that investing is a single-minded
process in which the investor bets the ranch on what appears to be "the
best at the price." Investors diversify their investments, because diversification is their best weapon against variance of return. "Diversification,"
Markowitz declares, "is both observed and sensible; a rule of behavior
which does not imply the superiority of diversification must be rejected
both as a hypothesis and as a maxim."

The strategic role of diversification is Markowitz's key insight. As
Poincare had pointed out, the behavior of a system that consists of only
a few parts that interact strongly will be unpredictable. With such a system you can make a fortune or lose your shirt with one big bet. In a
diversified portfolio, by contrast, some assets will be rising in price even
when other assets are falling in price; at the very least, the rates of return
among the assets will differ. The use of diversification to reduce volatility appeals to everyone's natural risk-averse preference for certain rather than uncertain outcomes. Most investors choose the lower expected
return on a diversified portfolio instead of betting the ranch, even when
the riskier bet might have a chance of generating a larger payoff-if it
pans out.

Although Markowitz never mentions game theory, there is a close
resemblance between diversification and von Neumann's games of
strategy. In this case, one player is the investor and the other player is
the stock market-a powerful opponent indeed and secretive about its
intentions. Playing to win against such an opponent is likely to be a sure
recipe for losing. By making the best of a bad bargain-by diversifying
instead of striving to make a killing-the investor at least maximizes the
probability of survival.