I N T R O D U C T I O N
“We have now begun the important job of trying to document and understand
how investors, both amateurs and professionals, make their portfolio
choices.” –Nicholas Barberis and Richard Thaler [2003]
Since Harry Markowitz wrote his groundbreaking paper, “Portfolio Selection”, in 1952, investment
professionals have been schooled in a well-known approach to portfolio management. The goal is to
build efficient portfolios, those that maximize return for a given level of risk. Efficient portfolios are
combined to create an efficient frontier of return opportunities. Investors then select from the frontier,
choosing a portfolio that matches their risk tolerance.
The Markowitz approach to portfolio selection led to the development of modern portfolio theory and
influences most investment processes used today. It was subjected to a severe test during the recent
bear market. As U.S. equity prices fell by 49% from the peak in March 2000 to the trough in October
20021, the strengths and weaknesses of traditional investment methods were exposed.
The bear market reinforced the benefits of diversification, which is the key to portfolio efficiency and
underpins Markowitz’s work. The principle of diversification is as simple as it is powerful. By spreading
a portfolio among a variety of investments, investments that are performing poorly are balanced by
those that are performing well, resulting in a more consistent pattern of returns. Many investors found
that diversification mitigated the effects of falling stock prices. Consider Tiger Woods, better known for
his golf game, who gave this confident response to a reporter’s questions about volatility in the midst of
the bear market: “That’s one of the reasons why you diversify yourself.” Other investors failed to
diversify and fared poorly as a result, such as those who were concentrated in technology stocks.
In most cases, however, even well-diversified investors were unprepared for the full extent of the bear
market. Many had implemented strategies in rising markets with neither clear objectives nor a clear
understanding of the risks. As they were forced to rethink their strategies, investment practices have
come under greater scrutiny. Areas where traditional methods have been disappointing, including goal
setting and risk assessment, have received particular attention. More broadly, the investment
community is seeking new approaches that are less reliant on traditional investment throry.