This discussion with Harry Markowitz took place at the Research Affiliates Advisory Panel Conference, Laguna Beach, California, 30 May 2014.
Markowitz’s pioneering work on portfolio management was first conceived in 1950 and appeared as Portfolio Selection in 1952. It proposed investors should act according to the expected return and risk along an efficient frontier, and became known as Modern Portfolio Theory. Markowitz won the Nobel Prize for Economic Sciences in 1990. He now divides his time between teaching and consulting, and he is co-founder of GuidedChoice, a managed account provider and investment adviser.
The traffic between San Diego and Laguna Beach has been heavy all day, and Harry Markowitz is running a few minutes late for his meeting with me. I am about to meet one of the legends of the wealth management industry, and he starts by apologising for his long journey. He’s nearly 87 years-of-age and no longer nimble on his feet, and yet it’s soon apparent that the mind is as sharp as the young economist who studied with Milton Friedman. Every second sentence is still a wise crack. He’s in the middle of writing four volumes on ‘Risk-Return Analysis: the Theory and Practice of Rational Investing’, and is contracted to deliver the final volume in 2019, “So I have to live until at least then”, he says.
Markowitz identifies the development of databases and ability to model expected outcomes as the major recent improvements in his portfolio construction work. Given a set of investments with forward-looking returns and defined risks, portfolio theory will show an efficient frontier for the investor. This principle has guided asset allocation and diversification for the 64 years since his original ideas. Says Markowitz, “I lit a small match to the kindling, then came the forest fire.”
Markowitz tells me he has a wall in his office dominated by a cork board, and on it, a large graph shows returns over time from various asset classes. It shows $1 placed in small cap stocks in 1900 growing to $12,000, while the bond line has reached $150. I asked whether this shows that for anyone with a long-term investment horizon, their portfolio should be heavily dominated by equities, maybe even 100%. He said he is asked this asset allocation question all the time. His advice is different to a waitress in a coffee shop versus a well-informed investor with good professional advice. He tells the waitress to go 50/50, a mix of growth from a broad stock fund and security from bank deposits, because she cannot tolerate the volatility of a 100% equity portfolio. But an educated investor with good advice should take their current portfolio mix, find the most efficient frontier, then simulate possible future outcomes focusing on income expectations. The investor can then better judge whether the portfolio is the right mix to achieve the end goals.
Markowitz believes active stock selection is for a few highly skilled people who usually find returns not from stock-picking on the market, but by participation in private placements. He cites Warren Buffett and David Swensen (of Yale University) as consistently delivering excess returns but mainly because of the private deals they are offered and their ability to value them. Otherwise, outperformance is not worth chasing.
His own portfolio is currently equally weighted municipal bonds and equities, the latter with an emphasis on small caps and emerging markets, but with a stable core of blue chips. This is because he feels so many stocks are overvalued at the moment, and his portfolio is also influenced by his age. “I want enough bonds that if I die, and the equity market goes to zero, my wife will have enough capital and income to live well.” His current objective is to reach 100 without appearing on the right-hand column of The Wall Street Journal, with the heading “Harry Markowitz f*cked up”.
He is a great believer in rebalancing, and this is one reason why a cash reserve is always required. As equity markets rise, shares should be sold to retain the same proportional asset allocation mix. This provides a natural protection from overvalued stocks. He recalled working with a major Fortune 500 client in November 2008, after the rapid stock market fall, allocating more to equities in a rebalancing exercise. This has subsequently paid off handsomely. But it was scary at the time, and as the market continued to fall, he thought if he keeps allocating more to equities at this rate, the whole place will be owned by him and Buffett. He likes the expression ‘volatility capture’ for this process, which is why there is a role for bonds as part of the reallocation mix.
I was still curious why a person with good savings at age of say 40, and strong income flows, would not invest 100% in equities, given their long term outperformance versus cash or banks. He said, “They may think their income is assured, but then may hit a rough patch and need to sell equities at the worst moment.” He highlighted that many people have jobs which are also heavily exposed to the strength of the economy, and that they should also “diversify their own job and other income sources”. He suggests investors should not become too smart, using leverage and unusual investments, and not try to become rich overnight.
He is also keen on using simulation to determine possible future outcomes. In his financial advice business, GuidedChoice, and especially in their new work on GuidedSpending, they ask clients to define an upper band of future income requirements, which might be say $50,000. Clients then define a ‘scrape through’ amount, such as $30,000. Simulations are done based on variables such as living longer and market returns “to capture the essence of the spending problem”. Clients can vary scenarios to see the outcomes. The most common consequence of the process is that people save more, often dramatically and commonly 50% or more. While the technology behind the scenes is complex in this modelling, it is presented in ways the client can easily understand. But he dislikes mechanical rules such as taking 4% from the portfolio each year. “Why should someone who is 90 only take 4% if they want to spend more?” he says.
I ask him how a fund with investors aged from 16 to 90 should allocate its assets. “It’s like a family,” he responds. “There is a trade off in a family structure between paying for the education of the children, versus the future retirement of the parents. All families make these ‘social choices’, and so must the fund. Their decisions may not be ideal for the 16 year old or the 90 year old but everyone makes these choices in life”.
And one of Markowitz’s choices is to keep working as hard as ever. “I enjoy this, and what else would I do all day?” He now dedicates every Friday to writing to ensure he meets his deadlines, spends every Thursday afternoon at GuidedChoice where he consults to their institutional clients, and he maintains a heavy teaching and advising schedule. If his health allows it, he’ll still be doing it when he’s 100, and that right hand column of The Wall Street Journal will be singing his praises.