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THOSE WHO LIVE VERY long lives sometimes face an unfair irony: The accomplishments of even towering figures can lose their luster over time—not because they’re proven wrong, but because the ideas they developed become so widely accepted that we forget they were once innovations. The investment world lost one such towering figure last week: the economist Harry Markowitz, who was age 95.
Markowitz first came to prominence in the early 1950s, when his PhD thesis, titled “Portfolio Selection,” offered an entirely new approach to investing. Prior to Markowitz, what constituted investment theory would have fit on an index card. For years, in fact, the only framework available to investors was the “prudent man” rule, which had its roots in an 1830 court ruling. At issue in that case was the management of a trust which had been established for the benefit of Harvard College and Massachusetts General Hospital. Over time, the two institutions became unhappy with the trust’s performance and sued the trustee, arguing that he had been negligent.
The trustee prevailed, however. “All that can be required of a trustee,” the court wrote, “is to observe how men of prudence, discretion and intelligence manage their own affairs.” In other words, investment markets inherently carry risk. All an investor can do, therefore, is to exercise judgment in choosing investments.
This became known as the prudent man rule. Despite being highly subjective, it was the lens through which investments were evaluated for more than 100 years, until the economist John Burr Williams suggested a better way. In his 1937 book, The Theory of Investment Value, Williams developed the concept now known as intrinsic value. Williams introduced the idea with this poem:
A cow for her milk,
A hen for her eggs,
And a stock, by heck,
For her dividends
An orchard for fruit
Bees for their honey,
And stocks, besides,
For their dividends.
In other words, “a stock is worth only what you can get out of it.” And for that reason, share prices should reflect the profits of the underlying companies. While this might seem like an obvious concept today, Williams was the first to see it. This new quantitative approach to choosing investments offered a big step forward from the prudent man rule, which wasn’t quantitative at all.
Williams’s work in the 1930s led directly to Markowitz’s in the 1950s. As Markowitz described it, when he later received the Nobel Memorial Prize in economics, “The basic concepts of portfolio theory came to me one afternoon in the library while reading John Burr Williams’s Theory of Investment Value.”
Markowitz agreed with Williams’s approach to valuing individual investments. It was far better than the old prudent man approach. But Markowitz still saw it as incomplete. The shortcoming: While it’s important to evaluate individual investments, it’s equally important—if not more so—to consider how a collection of investments will work together in a portfolio. Markowitz was the first, in other words, to show investors how to effectively diversify a portfolio.
In his 1959 book, Portfolio Selection, adapted from his thesis, Markowitz provided this example: “A portfolio with sixty different railway securities, for example, would not be as well diversified as the same size portfolio with some railroad, some public utility, mining, various sorts of manufacturing, etc. The reason is that it is generally more likely for firms within the same industry to do poorly at the same time than for firms in dissimilar industries.”
As noted above, today this might seem obvious. But before Markowitz, it had never occurred to anyone. And it wasn’t just a casual observation. Portfolio Selection runs more than 300 pages and is dense with formulas. In it, Markowitz provided a framework for building optimal portfolios—those that offered either the maximum possible return for a given level of risk, or the least possible risk for a given level of return. Markowitz called these portfolios “efficient,” and presented them visually in a diagram he called the efficient frontier.
In the decades since Markowitz developed the efficient frontier, no one has challenged his math, the concept still stands and it’s a mainstay of finance 101 courses everywhere. His theories have received some criticism, though. In particular, many argue that the statistic Markowitz chose to measure risk—the standard deviation of an investment—isn’t valid.
Standard deviation, also known as volatility, is the degree to which a stock’s price tends to move in a relatively straight line or to bounce around. Consider the stock of a company like Procter & Gamble. P&G’s business is relatively stable, and thus its stock price is quite steady compared to the overall market. Now, let’s compare that to Amazon.com’s stock. Reflecting the business that it’s in and its growth rate, Amazon’s share price acts more like a roller coaster. From a mathematical perspective, Amazon’s stock has been far more volatile. But which would you have wanted to own?
Over the past 10 years, P&G’s stock has gained 154%—not bad. But Amazon’s shares have soared nearly 830%, reflecting its enormous profit growth. Through the lens of modern portfolio theory, however, we would deem Amazon’s stock very risky simply because it’s bounced around so much. Many see this conclusion as nonsensical. While Amazon may be an extreme example, it illustrates why volatility is a controversial idea.
While I agree that it’s difficult to distill risk down to a single number, this criticism is also a little unfair. That’s because, in his 1959 book, Markowitz explained why he chose volatility as a risk yardstick: “…for conservative investors, a loss of 2L dollars is more than twice as bad as a loss of L dollars.” Investors, in other words, are human. We really dislike losses. The uncertainty of a volatile stock can be upsetting, and the reality is that stocks like Amazon don’t only go up.
We saw this just last year. In 2022, when the S&P 500 dropped 19%, Amazon’s shares lost more than 50%, while P&G’s shares dropped less than 5%. It’s not hard to see why Markowitz saw volatility as being a reasonable proxy for risk. He was acknowledging that investors have emotions. In his book about risk, Against the Gods, Peter Bernstein notes that more volatile stocks have been more prone to permanent loss, so there’s both an emotional and a quantitative justification for that metric.
Over the years, others have tried to develop alternative risk measures. But as I discussed earlier this year, there is no single perfect measure. Each provides a different perspective. I find it helpful to consider different risk measures as a mosaic, allowing investors to form a more complete picture. It’s to Markowitz’s credit that he was the first to use any quantitative measure at all in attempting to assess risk. While volatility isn’t perfect, it’s certainly more rigorous than the old prudent man standard.
Putting aside this question, Markowitz’s lasting contribution is that he taught investors how to think about diversification, and few people debate that.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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Thanks Adam for the history lesson. When reading these types of articles for any topic (finance, medicine, etc.) I find it interesting to ponder what we are missing today that in 100 years will be obvious.
Love the reference to “Against The Gods!”
That poem and the conclusion “In other words, “a stock is worth only what you can get out of it.”
And for that reason, share prices should reflect the profits of the underlying companies.”
is something I often ponder and never understand.
The poem repeats “for their dividends”. That I get, earnings are shared with investors.
WHAT I DON’T GET is a stocks price rising when there are no dividends or dividends don’t increase with earnings. I know, it’s the anticipation of higher earnings, and dividends and yet there is nothing to say dividends will increase.
But then many investors buy a stock not for dividends, but growth. Growth based on what? Future higher earnings that are not shared directly with investors?
My utility stocks have taken a beating as interest rates rise, but nothing else has changed. The dividend has risen modestly, but is stable and yet analysts predict a stock price six dollars higher or three dollars higher – based on what that affects my dividend income?
I see nothing logical in the investment process because it does not share earnings with investors on a consistent or guaranteed basis.
This, by the way, is also a reason why it’s important to look at investments through more than one lens. A company’s P/E ratio, for example, overlooks cash on its balance sheet. Book-to-market and enterprise value, on the other hand, give companies credit for accumulated cash from prior years’ profits — and/or debt, if applicable.
Dick, it’s a great question, and I agree with Jonathan. If a company isn’t paying dividends, then the share price should track corporate profits because the company might one day initiate a dividend, it could use cash to buy back shares, or the company might be acquired.
This might seem highly theoretical, but a company like Apple provides a good illustration of this phenomenon in practice. In the years after Apple introduced the iPhone, it began to accumulate a mountain of cash, but it hadn’t paid a dividend since 1995 (see: https://investor.apple.com/dividend-history/default.aspx). But activist investors, including Carl Icahn, applied pressure, and eventually Apple restarted its dividend in 2012. That dividend has risen considerably in the years since. Apple has also done substantial buybacks (see: https://www.macrotrends.net/stocks/charts/AAPL/apple/shares-outstanding)
I’m not a big fan of hedge funds, mainly because I see them as overpriced, but this is an example of a useful role that they do play in keeping investment markets efficient.
Thanks for answering, Adam
Berkshire Hathaway, the archetypical value investor company, has never and likely will never pay a dividend. You’re buying an earnings machine and must sell shares to convert gains to income.
That be the case and investors knowing that when they buy, isn’t the growth of the stock price nothing but speculation since apparently they will never actually share in the earnings?
In that case if earnings stayed flat for ten years, the stock would no doubt decline in value, but why since there was no real sharing of the earnings in any case except by way of stock price because of someone speculating earnings would continue to increase.
Hi Dick.
I’d think of your home: Your home doesn’t pay a dividend, but the equity accumulation in it is definitely real.
You receive dividends from your Utility stocks, and you either spend them, store them in a bank account, or reinvest them to buy more shares in the Utility (or some other investment), yes?
We Berkshire holders do essentially the same thing, but we entrust Warren Buffett to make those decisions at the corporate level, rather than us making them at our individual level.
Berkshire has $35 billion of earnings pour into it’s corporate coffers annually (in 2022, anyway), and we trust Buffett to decide what to do with all of that cash.
It’s not speculation, though. It’s a massive cash machine, with a growing Net Worth that we shareholders have a legal claim to, just like your claim to your home equity (and with the real estate and stock markets determining the perceived price of that equity and Net Worth on a regular basis).
Yes in the same way we’re speculating a dividend payer will continue to pay at or above the same level going forward. If a company like Berkshire has decades of history growing operating earnings, it doesn’t seem to be a highly speculative wager that this might continue. At least to the extent that any history can be a guide to future outcomes. Your mileage may vary.
And there will be a time when Berkshire starts paying a dividend or buying back stock, probably after Buffett’s death. New management will conclude that such a large company can no longer continue to generate superior growth and will start passing along cash to shareholders, and lots of it. At that point, it’ll be crystal clear that the stock’s earlier huge gains were entirely justified, as shareholders collect oodles of cash that they can then redeploy to other investments that promise better returns. That’s the lifecycle of companies: Rapid growth early on when they’re small and nimble, slower growth later, at which point they start returning cash to shareholders. How long does this lifecycle last? Sometimes it isn’t long at all, while in other cases, such as Berkshire, it’s extraordinarily long.
It’s perfectly logical. Investors buy growth companies because they know that, down the road, these companies will have ample cash flow to pay out dividends and buy back stock. But for now, shareholders are happy to see these companies plow back money into the business, knowing it’ll mean even bigger dividends and buybacks down the road. There’s nothing terribly mysterious to all this.
Yes perfectly logical. I’ve noticed there is a narrative out there I call the deep value narrative where people claim growth % rate is more important than magnitude of cash delivered over time (projected of course). As if you’d rather have 10% of $100 than 5% of $400 lacking some belief about growth longevity and eventual magnitude change. Recall the claims that Apple returns couldn’t continue because of “the law of large numbers.”
Thanks for the history lesson, Adam. It is amazing how obvious some innovations look in retrospect when they eluded all of humanity for most of our existence.