Economics (McConnell) AP Edition, 19th Edition

Chapter 34: Financial Economics

Origin of the Idea

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=gif::::/sites/dl/free/0217511447/124310/origins_image.gif','popWin', 'width=70,height=90,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (1.0K)</a> 34.1 Portfolio Diversification

The idea that we shouldn’t “put all of our eggs in one basket” has been around for a long time, but it was economist Harry Markowitz who formalized models to determine how best to diversify those “eggs” (our financial wealth) among different “baskets” (the various financial assets available).

Basic portfolio theory of the time held, as one might expect, that investors want to maximize their discounted expected return. If this were the only objective, however, the rational investor would put all of his or her financial wealth into a single asset – the one with the highest anticipated return. Markowitz recognized that most investors do not behave this way. He understood that while investors are motivated to maximize returns from their financial investments, they are also aware of and try to minimize risk.

The hypothesis (or maxim) that the investor does (or should) maximize discounted return must be rejected. If we ignore market imperfections the foregoing rule never implies that there is a diversified portfolio which is preferable to all non-diversified portfolios. Diversification 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.⁽¹⁾

Markowitz introduced variance as a measure of risk. As you may know from the study of statistics (or may soon learn), variance measures how much a variable deviates from its mean (average). In terms of portfolio selection, the mean refers to the average expected return of an asset. Suppose that a particular company stock is expected to increase in value five percent each year. If the variance for that stock is low (at or close to zero), one can rely on the five percent return each year. If the variance is high, that stock might return ten percent one year and negative two percent the next, only averaging out to a five percent return over longer periods of time. At extreme variances, that five percent expected return may simply be the average between a potential huge payoff (well above five percent) and the company going bankrupt, resulting in a total loss for investors.

Rather than balancing risk and return over individual assets, Markowitz saw investors balancing over their portfolio. He recognized that different investors have different appetites for returns and tolerance for risk, so the appropriate level of diversification varies across investors. Furthermore, Markowitz recognized that there may be a tradeoff between returns and risk.

The portfolio with maximum expected return is not necessarily the one with minimum variance. There is a rate at which the investor can gain expected return by taking on variance, or reduce variance by giving up expected return.⁽²⁾

One investment rule of the time argued that one could adequately minimize risk and achieve high returns simply by spreading funds across all of the different financial assets with the highest expected rates of return. This rule was based on the “law of large numbers.” This law suggests that with a sufficiently large portfolio of securities, even if a small number fail to deliver the expected returns, others in the portfolio will make up the difference so that the average return for the portfolio as a whole matches the average of the expected returns of the individual assets in the portfolio. Markowitz rejects this rule, claiming that the “returns from securities are too intercorrelated. Diversification cannot eliminate all variance.”⁽³⁾

This “intercorrelation,” known statistically as covariance, refers to the fact that the returns to a particular asset sometimes are related to the returns of other assets – that fortunes are sometimes tied together. Firms in the same industry, for example, will be subject to the same general market forces. As Markowitz explains,

The adequacy of diversification is not thought by investors to depend solely on the number of different securities held. 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.

Similarly in trying to make variance small it is not enough to invest in many securities. It is necessary to avoid investing in securities with high covariances among themselves. We should diversify across industries because firms in different industries, especially industries with different economic characteristics, have lower covariances than firms within an industry. ⁽⁴⁾

For his efforts, specifically for his article “Portfolio Selection” that appeared in The Journal of Finance in 1952, Markowitz shared the 1990 Nobel Memorial Prize in Economics (along with Merton Miller and William Sharpe) for “pioneering work in the theory of financial economics.” As explained in the Royal Swedish Academy of Sciences announcement of the prize, “Markowitz’s work on portfolio theory may be regarded as having established financial micro analysis as a respectable research area in economic analysis.” (Press release, Oct. 16, 1990, http://nobelprize.org/nobel_prizes/economics/laureates/1990/press.html)

Markowitz was born in Chicago in 1927, where he earned his Bachelor of Arts and Doctoral degrees in economics from the University of Chicago.