In Pursuit of the Perfect Portfolio: a review

A new book by Andrew W Lo and Stephen R Foerster profiling key figures in the development of modern portfolio theory offers a fresh perspective on the active versus passive debate

Markowitz’s insight

But the principles that guide contemporary portfolio management only began to evolve in the post-war years with the pioneering work of economist Harry Markowitz. In a sense modern investment theory is one long commentary on Markowitz’s insight — which came to him one afternoon as a graduate student while working on a paper in the University of Chicago library — that investors should select securities with regard to the role they will play within the context of a portfolio rather than their merits as independent investments. As Lo and Foerster put it:

The efficient market hypothesis

Aside from Markowitz, the central figure in the book, perhaps, is Eugene Fama, another Chicago School luminary, whose work continues to provoke some of the sharpest disagreements in the investment world. Fama’s efficient market hypothesis (EMH) pushed Markowitz’s thought on the virtues of diversification to its logical conclusion, maintaining that if information in a market is open to all participants, and participants process that information rationally, then the price of a security will always accurately reflect its value.

Popularising passive principles

Lo and Foerster profile three well known figures who have popularised the Chicago philosophy through best selling books and passive investment products. In his best selling Winning the Loser’s Game (1998) investment consultant Charles Ellis helped foster increasing investor scepticism regarding the value of active funds, insisting that few fund managers beat the market for any length of time and that it is impossible to identify in advance those who will do so. Investors with the patience sit tight and track market over a 15 to 20 year period are guaranteed to secure better returns than 80% of their peers.

Alternative views

Lo and Foerster round off the book with a set of profiles that serve as something of a counterweight to the prevailing balance towards passive investment. Myron Scholes has close affinities with the Chicago School and the wider world of passive investment, having studied and worked with Eugene Fama and contributing to the development of Jack Bogle’s first Vanguard index fund. But for him those experiences highlighted the compromises inherent in the passive approach.

Beyond the EMH

As Lo and Foerster note in the book’s concluding chapter, the only points on which all of their subjects are in agreement are the fundamental importance of Markowitz’s insight into the value of a diversified portfolio, and the usefulness of a market portfolio, representative of all assets in the global market, as a starting point for portfolio construction.



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