Understanding the History of the Modern Portfolio

When talking about investment portfolios, very few people are confused by the term. An investment portfolio is a collection of income-producing assets that have been bought to meet a financial goal. If you went back 50 years in a time machine, however, no one would have the slightest clue what you were talking about. It is amazing that something as fundamental as an investment portfolio didn't exist until the late 1960s. The idea of investment portfolios has become so ingrained that we can't imagine a world without them, but it wasn't always this way.

In this article, we will explore the evolution of the modern portfolio from its humble beginnings in an unremarkable, and largely ignored, doctoral thesis, all the way to its current dominance, where it seems nearly everyone knows what you mean when you say, "you better diversify your portfolio."

The Beginning of Portfolio Theory

In the 1930s, before the advent of portfolio theory, people still had "portfolios." However, their perception of the portfolio was very different, as was the primary method of building one. In 1938, John Burr Williams wrote a book called The Theory of Investment Value that captured the thinking of the time: the dividend discount model. The goal of most investors was to find a good stock and buy it at the best price.

Whatever an investor's intentions, investing consisted of laying bets on stocks that you thought were at their best price. During this period, information was still coming in slowly and the prices on the ticker tape didn't tell the entire story. The loose ways of the market, although tightened via accounting regulations after the Great Depression, increased the perception of investing as a form of gambling for people too wealthy or haughty to show their faces at the track.

In this wilderness, professional managers like Benjamin Graham made huge progress by first getting accurate information and then by analyzing it correctly to make investment decisions. Successful money managers were the first to look at a company's fundamentals when making decisions, but their motivation was from the basic drive to find good companies on the cheap. No one focused on risk until a little-known, 25-year-old grad student changed the financial world.

Harry Markowitz and Modern Portfolio Theory (MPT)

The story goes that Harry Markowitz, then a graduate student in operations research, was searching for a topic for his doctoral thesis. A chance encounter with a stockbroker in a waiting room started him in the direction of writing about the market. When Markowitz read John Burr Williams' book, he was struck by the fact that no consideration was given to the risk of a particular investment.

This inspired him to write "Portfolio Selection," an article first published in the March 1952 Journal of Finance. Rather than causing waves all over the financial world, the work languished on dusty library shelves for a decade before being rediscovered.

One of the reasons that "Portfolio Selection" didn't cause an immediate reaction is that only four of the 14 pages contained any text or discussion. The rest were dominated by graphs and numerical doodles. The article mathematically proved two old axioms: "nothing ventured, nothing gained" and "don't put all your eggs in one basket."

The Investor and Risk Tolerance

The interpretations of the article led people to the conclusion that risk, not the best price, should be the crux of any portfolio. Furthermore, once an investor's risk tolerance was established, building a portfolio was an exercise in plugging investments into the formula.

"Portfolio Selection" is often considered in the same light as Newton's Philosophiae Naturalis Principia Mathematica—someone else would have eventually thought of it, but they probably would not have done so as elegantly.

How Modern Portfolio Theory Works

Markowitz's work formalized the investor trade-off. On one end of the investing teeter-totter, there are investment vehicles like stocks that are high-risk with high returns. On the other end, there are debt issues like short-term T-bills that are low-risk investments with low returns. Trying to balance in the middle are all the investors who want the most gain with the least risk. Markowitz created a way to mathematically match an investor's risk tolerance and reward expectations to create an ideal portfolio.

He chose the Greek letter beta to represent the volatility of a stock portfolio as compared to a broad market index. If a portfolio has a low beta, it means it moves with the market. Most passive investing and couch-potato portfolios have low betas. If a portfolio has a high beta, it means it is more volatile than the market.

Despite the connotations of the word volatile, this is not necessarily a bad thing. When the market gains, a more volatile portfolio may gain significantly more. Meanwhile, when the market falls, the same volatile portfolio may lose more. This style is neither good nor bad, it is just prey to more fluctuation.

The Impact of Modern Portfolio Theory

The theory gave investors the power to demand portfolios that fit their risk/reward profile rather than having to take whatever their broker gave them. Bulls could choose more risk; bears could choose less. As a result of these demands, the Capital Asset Pricing Model (CAPM) became an important tool for the creation of balanced portfolios. Together with other ideas that were solidifying at the time, CAPM and beta created the Modern Portfolio Theory (MPT).

The Bottom Line

The implications of MPT broke over Wall Street in a series of waves. Managers who loved their "gut trades" and "two-gun investing styles" were hostile toward investors wanting to dilute their rewards by minimizing risk.

The public, starting with institutional investors like pension funds, won out in the end. Today, even the most gung-ho money manager has to consider a portfolio's beta value before making a trade. Moreover, MPT created the door through which indexing and passive investing entered Wall Street.