The Big Bang Theory of Finance: Portfolio

The 'Big Bang Theory' speaks of the universe's beginning and the origin of all things. In finance, 'Portfolio Theory' is defined as the Big Bang Theory of finance, reflecting its monumental significance in the history of financial development. Its founder, Harry Markowitz, was awarded the Nobel Prize in Economics in 1990 for this groundbreaking work."

 

Making abstract concepts computable.

 

The core idea of Portfolio Theory is that investors can reduce the overall risk of their portfolio by diversifying across different assets based on their correlations and volatilities. By combining different assets, the decline in the price of some can be offset by the excellent performance of others, thus achieving risk diversification. This is known as 'diversification' or 'diversified' investing. Markowitz famously stated, 'Diversification is the only free lunch.' For instance, focusing solely on a specific stock's expected risk and return is insufficient; diversifying across multiple stocks can significantly reduce the portfolio's risk. This is commonly called 'not putting all your eggs in one basket.’

 

However, this isn’t where the theory shines the brightest. Portfolio Theory is revered as the 'Big Bang Theory of Finance' because it introduced the language of mathematics to finance, creating a unique methodological approach within the field. It placed finance within a quantitative framework, transforming it into a data-driven science.

 

Before Markowitz, before the 1950s, it was well-known that financial markets were risky, but the understanding of risk was incredibly vague. Little was known about how to measure or calculate it.

 

While pursuing his doctorate at the University of Chicago, Markowitz realized investors weren’t overly concerned about a company's specifics when discussing investment risk. What truly mattered to them was whether they could profit from the company or the investment.

 

In financial terms, investors care about the uncertainty of investment returns. He transformed an abstract concept of risk into a computable variable and then created a general framework for analyzing risk and return. Markowitz regarded the price volatility of securities as mathematical random variables. Thus, the expected return is the mathematical expectation of this random variable. Risk, then, can be described by the distribution of the random variable. If the variable follows a normal distribution, the risk is defined as the variance or the extent to which the return deviates from the mean.

 

Viewing investment returns as a mathematical random variable and using this variable to describe its returns and risks may seem like a simple step. However, this transformed an abstract and vague concept into a precisely quantifiable number, simplifying the problems for various investors.

 

Previously, everyone was concerned with matching risk and return. Now, it has become straightforward—a matter of mathematical optimization to calculate how much money to invest in which securities, determining which investment combinations minimize risk or maximize returns.

 

With Markowitz's theory, a framework for analyzing the trade-off between risk and return officially became the foundational analytical framework in finance. Over the past half-century, no matter how sophisticated finance has become or how complex and abstruse its mathematical equations have grown, the fundamental concepts behind all financial decisions have remained unchanged. They revolve around how to reduce risk and increase returns. Consequently, pricing financial assets has become a matter of finding returns appropriately matched with risk.

 

The Starting Point of the Modern Securities Investment Industry

 

Not only did it establish the foundation for this academic discipline, but it essentially created the securities investment industry.

 

Based on Markowitz's framework, the methodology for securities investment was developed. Before Markowitz, securities investment was primarily a matter of individual stock analysis, resembling a dispersed and uncoordinated effort. After Markowitz, securities investment evolved into a system that could be replicated and expanded, gradually becoming a professionalized industry. In other words, this theory is the starting point for the discipline and the modern securities investment industry.

 

Before the 1950s, securities investment involved analyzing individual stocks, akin to the era of artisanal workshops. Benjamin Graham, the father of value investing, stood out in this era of manual securities analysis. After introducing Markowitz's theory, it became clear that securities investment was not just about analyzing individual stocks but about finding the optimal combination of investments. It required a comprehensive approach involving extensive calculations and analysis. Thus, the era of going it alone gradually came to an end.

 

For example, Markowitz's theory requires calculating a portfolio that minimizes risk and maximizes return, termed in financial language as the "efficient frontier." Finding the efficient frontier is not as simple as it sounds; it necessitates analyzing and inputting data for all securities on the market.

 

When there were only a few dozen stocks, individual stock analysis was manageable. Now, with thousands, even tens of thousands of stocks, bonds, gold, and various other investment products on the market, the task is much more complex. You must calculate the correlations between each group of assets, which involves not just dozens, hundreds, or thousands of operations, but millions, tens of millions, or even billions of calculations. This type of input cannot be achieved manually; it requires computers. Moreover, this not only demands high performance from computers but also imposes higher professional standards on security analysts.

 

Consequently, soon after this theory emerged, Wall Street quickly recognized its significance. Many investment banks invested substantial funds into researching data and performing linear programming.

 

We all know that the formation of a modern industry is based on standardized and scalable production. Things, products, and services that are non-scalable and non-replicable cannot form an industry. At most, they remain in the era of artisan workshops, as we mentioned earlier.

 

This methodology is akin to molds and assembly lines for industrial production—it can be replicated, propagated, and scaled up. Once an industry is formed, the efficiency of the entire financial market is greatly enhanced, and the allocation of global capital becomes more effective.

 

Markowitz's theory not only provided a concrete solution for risk diversification and laid the groundwork for future asset pricing, but more importantly, it introduced an analytical framework and established a methodology. This has driven our securities investments toward specialization and segmentation, creating a vast global industry.

 

Thus, academics regard it as the Big Bang Theory of finance, while Wall Street refers to it as "Wall Street's First Revolution."

 

In summary: Diversification and diversification are indeed the most effective ways to reduce risk.