It’s just human nature that no one wants to hear about reducing risk when there’s a bull market going on.
However, the minute the markets take a turn for the worse, and people start to realize their investment losses, the concept of risk reduction suddenly becomes an important topic.
So kudos to Stock, Futures and Options Magazine for their recent interview with Harry Markowitz. It’s a great read.
The first paragraph of the Wasendorf’s article pretty much sums up the contribution Harry Markowitz has made to the millions of individual investors who invest in 401ks and the like:
Today, the concept of investment diversification to optimize reward while minimizing risk is so ubiquitous that it seems preposterous to think there was a time when investors didn’t know about it. But there was.
Before the 1950s, there was hardly any theory whatsoever of financial markets. A first pioneering contribution in the field was made by Harry Markowitz, who developed a theory of portfolio decisions of households and firms under conditions of uncertainty. The theory shows how the multidimensional problem of investing under conditions of uncertainty in a large number of assets, each with different characteristics, may be reduced to the issue of a trade-off between only two dimensions, namely the expected return and the variance of the return of the portfolio.
Dr. Markowitz, is a Nobel Prize winning economist, whom along with two of his colleagues, pioneered the concepts of Modern Portfolio Theory (MPT) and financial economics, investment concepts that we often take for granted.
In essence, his discoveries showed that individual investors like you and me can reduce the risk (volatility) of our investments by diversifying our portfolios, while at the same time not greatly reducing the returns we would expect without diversification.
So, the next time you catch yourself saying:
“Boy, I’m glad that I also bought 1000-shares of XOM when I bought 1000-shares of WM.” or “It’s a good thing that I keep 1/4th of my mutual fund portfolio in TIPS.”, remember to thank Harry Markowitz.
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