The idea behind Modern Portfolio Theory — the process for selecting assets to maximize expected return, or conversely, minimize expected risk in a portfolio — came to Dr. Harry Markowitz as a young student at the University of Chicago. He recently shared the story of his discovery with Debra Baker, Head of BNY Mellon's Global Risk Solutions.
"I was at the stage where I had to pick a dissertation topic," Markowitz recalled. "So, I went to the head of my dissertation committee for a suggestion," says Markowitz, who in 1990 won the Nobel Prize in Economics. "He was busy, so I sat out in his anteroom." There, Markowitz chatted with a stock broker, who suggested the doctoral student apply mathematical statistical techniques to the stock market. Markowitz had found his topic.
Dubbed the "Father of Modern Portfolio Theory (MPT)," Markowitz continues to teach. He also conducts research with institutions like BNY Mellon, delving into investors' views on risk management and portfolio selection.
"We had such great success when we worked together in 2005," says Debra. "I understand you're still using some of the work of that paper in your teachings." As it turns out, Markowitz has made it required reading for students of his MPT course at the University of California, San Diego.
He advises students to pay attention to certain parts of the published survey. For example, the fact 85 percent of respondents said they regularly or occasionally used Modern Portfolio Theory. "Pension and endowments in 2009 was somewhere around the 25 trillion (dollar) mark," he says. "Let's suppose it's up to 30 trillion (dollars) — anything like 50 percent to 80 percent of 30 trillion (dollars) gets to be 15 or 20 (trillion dollars) — as Dirksen said, 'A trillion here, a trillion there, adds up to real money.'"
What's significant about Modern Portfolio Theory is what it provides: a mathematically-based approach for managing and mitigating risk. Or, in Dr. Markowitz's own words, "a standard process that seems to be used almost universally."
Prior to 1950, there was no systematic method for portfolio selection and corresponding risk management. But according to Baker, it was to Dr. Markowitz who provided the framework, a theory that has guided institutional investors for decades.
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