Harry Markowitz has died. He won the Nobel prize in economics in 1990, jointly with Merton Miller and William Sharpe “for their pioneering work in the theory of financial economics.”
I won’t try here to review how Markowitz’s work underlies the capital asset pricing model (“cap-M,” as economists pronounce it) that is now a fundamental part of finance and business school classes. Some readable and accessible starting points for the details are Markowitz’s Nobel lecture and an overview article by Hal Varian, “A Portfolio of Nobel Laureates: Markowitz, Miller and Sharpe,” in the Winter 1993 issue of the Journal of Economic Perspectives.
For me, the most fundamental part of Markowitz’s work was that he, as much as anyone, brought finance under the umbrella of what was understood to be “economics.” Markowitz told a story to illustrate this point in a number of interviews: here’s the version from the Journal of Financial Planning in May 2010. To set the stage, it’s 1955, Markowitz has been working at the Rand Corporation in California, but he needs to fly back to Chicago for the oral defense of his doctoral dissertation. Markowitz says:
“I remember landing at Midway Airport thinking, ‘Well, I know this field cold. Not even Milton Friedman will give me a hard time.’ And, five minutes into the session, he says, ‘Harry, I read your dissertation. I don’t see any problems with the math, but this is not a dissertation in economics. We can’t give you a Ph.D. in economics for a dissertation that isn’t about economics.’ And for most of the rest of the hour and a half, he was explaining why I wasn’t going to get a Ph.D. At one point, he said, ‘Harry, you have a problem. It’s not economics. It’s not mathematics. It’s not business administration.’ And the head of my committee, Jacob Marschak, shook his head, and said, ‘It’s not literature.’
“So we went on with that for a while and then they sent me out in the hall. About five minutes later Marschak came out and said, ‘Congratulations, Dr. Markowitz.’ So, Friedman was pulling my leg. At the time, my palms were sweating, but as it turned out, he was pulling my leg …”
There’s a minor dispute over whether Friedman was indeed serious: it’s not clear to me that Friedman was just goofing. Yes, Friedman wasn’t ultimately willing to block this dissertation. However, in a later interview, Friedman did not recall the episode but said: “What he [Markowitz] did was a mathematical exercise, not an exercise in economics.”
But in Markowitz’s Nobel his acceptance lecture back in 1990, he ended by telling a shorter version of this story, and then said: “As to the merits of his [Milton Friedman’s] arguments, at this point I am quite willing to concede: at the time I defended my dissertation, portfolio theory was not part of Economics. But now it is.”
In Varian’s JEP article, he quotes a 1990 comment from Robert Merton (who would share the Nobel prize in 1997 with Myron Scholes for work on to value derivative financial instruments): “As recently as a generation ago, finance theory was still little more than a collection of anecdotes, rules of thumb, and manipulations of accounting data. The most sophisticated tool of analysis was discounted value and the central intellectual controversy centered on whether to use present value or internal rate of return to rank corporate investments.” As much as anyone, Markowitz brought to economics and finance the ideas that financial choices involved systematic tradeoffs between risk and return, and that risks needed to be assessed in the context of an overall portfolio rather than one investment at a time. Such ideas and their implications were radical at the time; now, they are commonplace.
