The Father of Portfolio Theory Bets on Rebuilding
Mary Childs
Harry Markowitz, a Nobel Prize winner and the father of modern portfolio theory, has invested 100% of his liquid assets in the stock market, betting that the destruction from last year’s hurricanes will bolster industries involved in the reconstruction.
“It’s for the long run, but not the indefinite long run,” he says. “My thought process is this: They are someday going to rebuild Houston. It will take a while, but they’ll rebuild Houston. They’re going to rebuild Florida....And they’re going to rebuild Puerto Rico.”
Now 90, Markowitz won the Nobel in 1990 for his theory of “portfolio choice,” which holds that investors can allocate their money, even amid uncertainty, to maximize their expected return based on how much risk they are comfortable taking. Developed in the 1950s, the theory demonstrates the utility of diversification—that a portfolio’s different constituent assets will be less correlated with each other, thus preserving return but with lower overall risk.
He is working on the next two volumes of a four-part series called Risk-Return Analysis, subtitled The Theory and Practice of Rational Investing. “And that’s a lie,” he adds. “It’s really rational decision-making”—examining what we know, how we know it, and how it relates to action under uncertainty.
The fourth volume will consider how things interact with each other in a chain of reactions.
Which is what got him thinking about the hurricanes.
“My knowledge is inference and action,” he says. “I never did a study of the construction industry, but I know there’s walls there, and glass there, and if you want to get rid of rubble,” you will need the right equipment, he says.
At the same time, he had a revelation about his retirement savings. “It took a while to realize that money in my IRA—that should be working, just like the ones out of my IRA. My TIAA and Social Security essentially is fixed income, but everything that’s liquid I moved from bonds. I had a couple million.”
Markowitz put one third of his liquid assets into large-cap stocks, one third into an iShares fund tracking small-caps, and one third into an iShares fund tracking emerging markets.
But that wasn’t quite right.
“Then I said no, no, no, let’s take the one-third big cap and split it equally among six equities,” he says. He picked Weyerhaeuser (ticker: WY) to represent the lumber that would be needed, USG (USG) for the wallboards, Corning (GLW) for the glass, Caterpillar (CAT) because “think of how many bulldozers they’re going to need all over Puerto Rico,” 3M (MMM) “for who knows what, replacing all the Scotch tape of the world, and mining, of course,” and, finally, United Technologies (UTX), which manufactures and maintains air conditioners and Otis elevators.
Markowitz usually prefers diversifying with passive investments. But he doesn’t think he is too heavily concentrated. He points to his two index-tracking funds and his fixed assets in the form of two houses, one to live in and one for entertaining.
“Whether you’re passive or active, in general, as a basic principle, depends on how much information you have,” he says. “Now, Warren Buffett and David Swensen, CIO of Yale University, they get offers that I don’t get and I bet you don’t get. They get information I don’t have, and they have staff which they have personally trained that can evaluate that information. I am passive, since I’ve got more money than I need.”
Markowitz may have the same information as everybody else, but he sees things differently: Even as news articles forecast that the stock market was getting too high and had to have a correction, Markowitz didn’t see it as out of line with the economy at all, especially when combined with the benefits of tax cuts and corporations repatriating money they’d kept overseas.
“I’m just looking at the statistics of the stock market—they are not looking one step beyond how the economy is doing or what the economy is likely to do. The economy is likely to rebuild Puerto Rico! We suddenly have a big influx of capital and an incentive to spend it, and we have an increase in supply and an increase in demand. But we are going to have economic activity at least until Puerto Rico is rebuilt, at which time I might be dead.”
For now, though, he teaches at the University of California, San Diego, and says that he has about a dozen clients with whom he consults, including GuidedChoice, a 401(k) advisory, and Research Affiliates, which sells smart-beta funds.
“I’m still in business, because what fun would it be to retire?” Markowitz asks. He sums up his business plan with a variation on a nursery rhyme: “Harry, Harry, quite contrary, how does your business grow? / I love to toil under the midnight oil / and my clients send me dough.”
He recently signed on as a research advisor to LongTail Alpha, a hedge fund run by a former Pimco quant, Vineer Bhansali, which focuses on protecting against low-probability outcomes—that is, guarding against the unexpected. After meeting at a conference, they went to lunch the day before Thanksgiving at Markowitz’s office, and Markowitz mentioned his current equity allocation. Bhansali was struck that “the person who basically invented diversification as we know it” was “not very diversified”—and he’s been right.
Bhansali wondered if volatility had to rise, or if they’d entered a world with permanently low yields and low volatility. “How would we know when the markets were ready to turn south?” he asked the economist.
Markowitz responded by asking if Bhansali had seen the Road Runner cartoons.
“You know how Wile E. Coyote chases Road Runner off the cliff and then finds himself hanging in space momentarily defying gravity before plummeting into the abyss,” Markowitz said. In other words, we’ll know when we look down.
For now, at least, Markowitz sees firm ground.
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