What is investing like?
Many people believe that modern finance began in 1952 when Harry Markowitz published his paper, “Portfolio Selection,” for which he was later awarded the Nobel Prize. His work lays out the mathematical basis for diversification. By combining uncorrelated securities, investors can reduce the riskiness of their portfolios without lowering returns.
But Markowitz had a problem. When he sat before his dissertation committee to defend his thesis, they didn’t know how to classify his work. “It’s not economics,” they objected. “It’s not mathematics. It’s not business. It’s not literature.” Eventually, the committee agreed that Markowitz had earned his doctorate. And the world is a richer place.
But what is portfolio management? It uses all these disciplines, but isn’t really part of them. In my assessment, it’s most like engineering. Portfolio managers need to find the most best way to reach a goal, given a set of constraints, working in a world of uncertain, partial information. Managers build portfolios using various components. Different elements have different functions: some lay the foundation, others raise the profile, still others provide protection. Individual securities are valuable to the extent that they improve the structure of the portfolio as a whole.
Shakespeare understood the engineer’s problem. At the outset of Henry IV Part 2, the rebels are assessing their strength. One them likens their task to that of a builder, who must survey the land, draw a model, and if it’s too costly, revise it. Otherwise he’ll end up with a half-built house and no money, “a naked subject to the weeping clouds, and waste for churlish winter’s tyranny.”
In the same way, investors must assess their assets and continually evaluate their plans, given the changing circumstances of the times. Investing is engineering—we’re designing and building our own futures.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!