Morningstar Advisor - June/July 2010 - 48

Morningstar Conversation

In 1959, I had a theory. I had a rationale, and so on. Now, we have an industry.
Harry Markowitz

looked at this book, I expected it to be entirely theoretical. To my delight, I discovered that much of it could be understood by a bright high school student. I highly recommend it. But back to the scenarios. Recently, we’ve developed a technology which takes thousands of scenarios and packs them into a single data element. I call this the Distribution String, or the DIST for short. As to this question about Mandelbrot versus the Student t-distribution with four degrees of freedom, if probability distributions were beer, then the Distribution String is a beer bottle. You can put anything in it. But let’s not forget you can also put poison in beer bottles, and there are some distributions that are so fat-tailed that even if you had a million scenarios, it would not be enough for dependable results. Essentially, the DIST is a pre-computed Monte Carlo simulation, and if your distribution is well behaved enough to be simulated in the first place, then the distribution string is completely agnostic.
Kaplan: So, if Harry were using it, he would put

Asset-Allocation Infrastructure
Kaplan: Harry, I want to go back to you. Sam and I called our article “Markowitz 2.0.” In that article, we said that what you did for the quantitative portfolio construction in 1952 was what the Wright brothers did for aviation. You made the key breakthrough that made it all possible.

fly basically like the Wright brothers flew. We have a means to pull the airplane through the air, and then the air flowing over the wings lifts the plane. You’ve got thrust and you’ve got the lift. We still don’t know how to flap our wings and fly around trees in a dense forest and land lightly on a branch. That’s flying! We do not know how to dive screaming down from the heavens, almost vertically straight down, pull out in time to grab a mouse in our talons, and fly off with it. That’s flying! But we do know how to put a lot of people in a big jet and serve them coffee, tea, or milk. That’s what’s old and new in aviation. What is still true in 2010, as true as it was in 1959, is the table on Page 121 of my book showing that if probability distributions are not too spread out, then mean-variance approximation will work very well. What is new is data, for example, like Morningstar data, formerly known as Ibbotson data. That has been very valuable to us. Another thing that’s new are the models of covariance, like Barr Rosenberg’s, and experimenting with different models of expected return, like the Fama-French Three Factor Model. I think the most important thing that happened between 1959 and the present is the notion of doing your analysis on asset classes in the first instance. This has become part of the infrastructure that we now rely on. In 1959, I had a theory. I had a rationale, and so on. Now, we have an industry.

But while the aviation industry has made enormous advances since the Wright brothers, the investment profession has largely done nothing beyond your 1952 work. Yet you, yourself, have been advocating major enhancements to your original model, beginning in your 1952 book. But your enhancements don’t seem to have been embraced by our industry. Why do you think the industry has been so slow in making changes to your basic model?
Markowitz: Let me point out that there are things that the aviation industry does just as the Wright brothers did, and there are other things that they have advanced considerably beyond the Wright brothers.

in the output of a Monte Carlo simulation of a Student’s t-distribution with four degrees of freedom.
Savage: Not only that, but I would be happy to

promote Markowitz in a bottle in the free market—that is to say, people should be free to choose which distributions to use in a particular setting. If these things were widely available on the Internet, the Markowitz brand would be a hot seller.

In our industry—the portfolio theory industry in the broadest sense—there are things that are just exactly like 1959. My thinking through of why to use mean-variance analysis, how to use mean variance, and so on, was not in the 1952 paper. That proposed mean variance; the rationale for it was presented in my 1959 book. So, let’s talk for a moment about what’s new and what’s old in the aviation industry. We still

Applying Scenarios to Portfolios
Kaplan: Sam mentioned that his introduction to the portfolio problem was not in putting together a portfolio of securities, but rather putting together a portfolio of oil exploration projects. In that context, he turned to the scenario approach, which, as we discussed, is flexible—you don’t have to make

48 Morningstar Advisor June/July 2010

Morningstar Advisor - June/July 2010

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2010