Harry Markowitz, who died this week, is one of those academics on whose work a lot of the world is built. 

Markowitz has been credited for everything from the invention of index funds (which save investors anywhere from $150-250 billion in fees per year) to the Global Financial Crisis (estimated total cost: more than $2,000 billion).

He’s one of those thinkers – like Einstein, Darwin or Keynes – who transformed his field. So what did he do?

Markowitz was a professor of finance at the University of California, San Diego. His big contribution was a theory of risk. 

Before Markowitz, investors thought mainly in turns of returns. That’s because returns are easily measured. But returns are only half the story.

Pre-Markowitz, investors had a certain intuition for risk — they knew not to keep all their eggs in one basket — but they didn’t have a systematic way to think about it. 

Markowitz came up with a way to think about risk and measure it, like-for-like, across different portfolios. He showed the risk was the other side of the coin from returns. More return meant more risk and vice versa. 

One implication was that there was more than one way to invest efficiently. That different types of efficient portfolios did different jobs. 

Mamdouh Medhat, a senior researcher and vice president at Dimensional fund managers said of Markowitz: “Before he came along things were kind of chaotic, because we didn’t have that theory to organise our thoughts. 

“Before he published his paper on the efficient frontier, people thought the only way to build a portfolio was to pick individual stocks or individual fund managers. What he found is a mathematical framework for ‘which framework should I choose, given the risk I want to take, and the return I want to achieve’. Mapping those two out gives you the efficient frontier.”

The second big implication of Markowitz’s work was the importance of diversification – the only free lunch in finance. The idea here is that by combining assets into a portfolio, you get the same amount of return with less risk. 

Markowitz’s work enabled the invention of the index fund in 1976. Indexes have gradually come to dominate the world of asset management. Index funds are investing-on-autopilot: funds whose assets are selected in accordance with pre-agreed rules. 

Indexes were made possible by Markowitz’s insight that the characteristics of an entire portfolio are more important than those of the individual investments within it. Their benefit to investors is that they’re much cheaper than actively managed funds. Starting from zero in 1976, Index funds have come to manage $11.2 trillion.

The global financial crisis

Markowitz said the risk of a portfolio could be quantified in terms of volatility, and lessened by diversification. 

His disciples took those ideas and ran with them. They came up with the concept of value at risk. Value at risk was heavily implicated in the collapse of much of the financial industry in 2008. 

The idea of value at risk is that it measures the amount of money that’s at risk of being lost in a defined period, at a defined confidence level. A confidence level is expressed as a probability. 

So if the value at risk of a portfolio of subprime homes is $10 million at a one-week, 95 per cent confidence level, that means there is only a five per cent chance the value of the asset will drop more than $10 million over any given week. 

Those notorious sub-prime mortgage securities got AAA ratings based on the value-at-risk framework. The banks who packaged the securities together argued that, through the magic of diversification, the idiosyncratic risk of individual mortgages going bad went away. By this reasoning were the foundations of the global financial system undermined.

The problem was, it turned out that the risks in those AAA mortgage securities were correlated to each other. When the economy slowed, the mortgages all went bad at once. A naive extrapolation of Markowitz’s theories led the finance industry over the precipice.

In The Black Swan, published a year before the financial crisis, Nassim Taleb took aim at Markowitz and his theory. He said: 

“But the [Nobel prize] committee has gotten into the habit of handing out Nobel Prizes to those who “bring rigor” to the process with pseudoscience and phony mathematics. After the stock market crash, they rewarded two theoreticians, Harry Markowitz and William Sharpe, who built beautifully Platonic models on a Gaussian base, contributing to what is called Modern Portfolio Theory. Simply, if you remove their Gaussian assumptions and treat prices as scalable, you are left with hot air. The Nobel Committee could have tested the Sharpe and Markowitz models— they work like quack remedies sold on the Internet—but nobody in Stockholm seems to have thought of it.”

For better or worse, Markowitz’s ideas permeate every part of the financial system.