"Portfolio Selection"
Foundational paper for thinking about portfolios; launch of Modern Portfolio Theory. For RP investors, key observations on how assets in a portfolio can be combined to produce same returns at lower risk, or higher returns at the same level of risk. Also has early ideas on the importance of correlation in a portfolio.
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Harry Markowitz
Important Points for the RP Investor:
The paper is only 14 pages long, of which the middle ten pages or so are very math-heavy explanations of Markowitz’s ideas. I’d say I’m about 30% comfortable with the math, but I still got a lot out of the paper just by reading the first three pages and the last three.
Markowitz was reacting in the paper to a dominant idea in finance at the time - that what investors essentially had to do was figure out the expected future dividends of companies and then concentrate their investments in the one(s) that looked the best (Markowitz was responding specifically to a 1938 book by J.B Williams). Markowitz then comes along and says that that theory is too simplistic because it doesn’t take into account the variance of returns over time, and doesn’t account for how different assets interact with each other. Markowitz proposes instead the maxim that investors do (or at least should) try to maximize return while minimizing variance, or the way returns differ from the mean.
Page 77: Markowitz says that the earlier approaches don’t stress the importance of diversification. For RP investors, diversification is a foundational insight, and you see early evidence of advocacy here.
Page 79: Markowitz writes: “There is a rate at which the investor can gain expected return by taking on variance, or reduce variance by giving up on expected return.” This seems like common place knowledge now, which is essentially the biggest compliment you can pay to Markowitz - his paper was the first to make observations so clear that it is hard to imagine they were NOT understood at some point.
Page 82: While I think most of the middle section can be skipped by average investors, there is a very useful (and famous) diagram that shows return on the X-axis and variance on the Y-axis with a circle showing possible combinations in a portfolio. The bottom right quarter-arc of the circle is (ever so slightly) bolded and represents “efficient” combinations. This means combinations of assets that represent the highest return, the lowest variance, or some combination between those two.
By the way, nowadays you’ll almost always see this diagram with the axes flipped (so, variance on the X and return on the Y).
Pages 87 and 89: Markowitz makes the case for thinking of portfolios in terms of both return and variance, and argues that his new “E-V rule” or Expected return-Variance of return” rule is a more logical framework for investors.
Page 89: A key section for RP investors with Markowitz’s discussion on diversification, and deserves quotation at length:
Laid out here is the starting point for Risk Parity: essentially that true diversification is not just variety but having dissimilar assets that will behave differently. Markowitz then goes on:
Yes! Yes! Yes!
Other Resources Related to this Paper:
Modern Portfolio Theory explained in 4 minutes:
Andrew Lo interviews Harry Markowitz for the "In Pursuit of the Perfect Portfolio" series:
A critique of Modern Portfolio Theory: