Harry Markowitz: The Key to Making Cheddar
Whenever I mention I study economics to strangers in conversation, I’m often half-jokingly asked whether I know of any good stocks to invest in. Studying economics apparently means I know all the secrets to what made Warren Buffett filthy rich. Unfortunately, these secrets have yet to be given to me, and I have to still live on a grad student’s income. There are a few good general tips to keep in mind. I figured I’d use one of the 1990 Nobel Laureates, Harry Markowitz, to help give a crash course on Modern Portfolio Theory.
Harry Markowitz won the Nobel Prize in Economics, along with William Sharpe and and Merton Miller, “for their pioneering work in the theory of financial economics”. For Markowitz, this is talking about his paper on Modern Portfolio Theory. Essentially, he incorporated the idea of risk into investment
Basically every decision you make when investing should consider balancing risk and the possible returns from investing. This can be done in a few ways, many of which you’ve probably heard from conventional investing advice.
Diversify Your Assets
Don’t keep all your eggs in one basket. You’ve heard this before. In fact, it’s probably the most boring part of any article or self-help video on investing. But, Harry Markowitz listed this as the best advice he could ever give about money, over any of his other tips on money. That must mean it’s worth listening to.
The reason investing pros beat this suggestion like a dead horse is because it is a great way to reduce the amount of risk you’re taking with investments. If you invest in 10 different firms, the odds that all of them bust is much lower than the odds that one firm busts, no matter how great you think the company is.
When you invest, you should do so in portfolios, or collections of investments into different companies. But, how?
The Efficient Frontier
Bear with me, this is going to get a little jargon-y. So you want some combination of risk and reward with your investments, right? Actually, I’m guessing you want the highest reward for the lowest risk possible. However, as you get higher and higher possible rewards, risk goes up with it. These general ideas create Markowitz’s Efficient Frontier.
As the picture above says, you want to make a portfolio as close to this curve as possible. Any portfolios below the line could have better returns and anything above the curve is impossible.
But Alex, my friend said I should invest in Madoff’s Ponzi Palooza, because risk is low and returns are high! All I have to do is buy these cutco knives and sell them to my friends, who can sell knives to their friends…
The general rule is, if somebody claims they can return higher returns for lower risk than anybody else, you should be suspicious. Buying a home has been the “staple” of low risk and high return. It has been labeled as one of the most important aspects of the American dream! But, that didn’t turn out so great in 2008. The housing market used to be considered high return for no risk, but the risk eventually caught up and created the largest financial crisis since the Great Depression of the 1930s.
Everyone can agree that when you invest you want to get the highest return for the lowest risk. The part where people differ is how much risk we’re willing to take in order to get higher rewards.
After all, some of us are extreme risk takers who jump out of planes without parachutes while others sit at home, drink carb free lemonade, and write blog posts.
This leads to three general types of portfolios available for investment.
- High risk, high return — This group includes investments like bleeding edge technology. If you think self driving flying cars are going to really soar in the next few years and want to get in before takeoff (pun very much intended), this area is your place to be.
- Medium risk, medium return — These are the groups you usually think of with investment. Facebook, Walmart, and Amazon are all great examples. These are the types of investments that the general risk averse public will be investing in. If you’re investing for the first time this is a good place to start.
- Low risk, low return — These are investments such as bonds and Mutual Funds. You’re going to get very low returns on them but hey, you’ll pretty much know it won’t be a loss. If you’re really afraid of losing money, this might be a good place to invest. Just remember not to buy into too low of rewards, or else the investment won’t be worth it.
In the end, following these tips will help us be better investors, and hopefully make more money in the process. It should be obvious, but none of these ideas are mine. These all were pulled from Markowitz’s brilliant Nobel winning paper. There’s a ton more to the model in this paper that I just can’t write out in a single blog. For example, how does Markowitz’s model account for market shocks such as the recession in 2008? Because, he claims that it does.
I know some of you may be disappointed. I guess there was no key to making cheddar after all. All I gave were general tips instead of telling you where to invest! You got to the end of this blog post and feel cheated, because all you got was a finance lesson. In that case buy Bitcoin and Ethereum. I hear they’re both really hot right now.
