The birth of portfolio theory

Everything in the first chapter was about a single question: can you predict prices? The answer was no, and it has stayed no. This chapter is about what a sensible person does once they accept that. Three papers, all from the early 1950s, written by three men who never met and who were answering the question from three different directions. Before them, a portfolio was just the pile of things a person happened to own. After them, it was something you could sit down and build on purpose.

Markowitz, 1952

Harry Markowitz was twenty-five, a graduate student in Chicago, sitting in a library reading John Burr Williams’s The Theory of Investment Value, the book that taught a generation how to value a stock. The book said you should buy whatever has the highest expected return. He noticed that if everyone did that, they would each own one stock, the best one, and nobody does that. People spread their money around. So either everyone was stupid or the book was missing something.

What it was missing was risk. Markowitz wrote it down in fourteen pages: an investor cares about the return of the whole portfolio and about how much that return can swing, and the swing depends less on how risky each holding is than on how the holdings move together. Two risky things that move in opposite directions make a calm portfolio. Two safe-looking things that move together make a fragile one. When he defended the thesis, Milton Friedman told him it was not economics. He got the Nobel Prize for it anyway, thirty-eight years later.

Here is what I take from it in practice. Most people think they are diversified because they own many names. Count something different: how many separate reasons do you have to make money? If everything you own goes up when rates fall and the economy grows, you own one bet with twenty tickers on it. I go through my own holdings once a year and ask what would have to be true for each one to do badly. If most of the answers turn out to be the same, then I have not diversified anything. I have only kept myself busy.

Roy, 1952

The same year, in Cambridge, an economist named A. D. Roy published almost the same idea with a completely different motive, and got almost no credit for it. Markowitz himself said later that Roy could claim an equal share of the invention. Roy had been an artillery officer in the war, which may explain the way he framed the problem. He was not interested in the best average outcome. He was interested in not being wiped out.

His rule is called safety first. Decide what level of loss would be a disaster, the number below which your life changes, and then build the portfolio that makes falling below that number as unlikely as possible. Everything else comes after. It is the same mathematics as Markowitz, pointed at a different target: not the top of the range, the bottom.

This is the paper that shaped how I invest more than any other, and it is the one almost nobody reads. In practice it means the first question about any portfolio is not “what could this earn” but “what is the worst year I can live through without changing anything important.” Write that number down before you buy anything. The word I use for a portfolio built that way is survivable.

Kelly, 1956

John Kelly was a physicist at Bell Labs who was thinking about noise on telephone lines and ended up solving a gambler’s problem. Imagine you have an edge, a bet that pays more often than it loses. How much of your money should you put on it? Bet too little and you leave money on the table. Bet too much and one bad run wipes you out, and it does not matter how good the edge was.

Kelly’s answer is a formula, but the idea behind it is what matters. There is a fraction of your capital that makes it grow fastest over time, and it is smaller than most people’s instinct. Go past it and your average results still look fine, but the path gets so bumpy that the probability of ruin climbs toward certainty. The formula does not care how confident you are. It only cares how much you can afford to lose and still be in the game next time.

In 2016 two former traders, Victor Haghani and Richard Dewey, ran an experiment that shows what happens without that rule. They gathered sixty-one people, all of them trained in finance, and gave each one twenty-five dollars and a coin. The coin, they were told, was rigged to come up heads sixty percent of the time. For thirty minutes they could bet as much as they wanted on each flip, heads or tails, and at the end they would keep whatever they had.

The right way to play is not complicated. With a sixty percent coin, betting the same modest fraction of your money on heads every time, somewhere around a fifth, gets almost everyone to the maximum payout. Almost nobody did that. Twenty-eight percent went broke. Eighteen of the sixty-one bet everything they had on a single flip. Two thirds bet on tails at some point, against a coin they had just been told was rigged the other way.

None of them lacked the arithmetic. What they lacked was a rule for how much to bet, decided before the first flip, that the excitement of the game could not talk them out of.

What to keep

Three habits, one from each man.

From Markowitz: count your reasons, not your holdings. Diversification is having money in things that fail for different reasons.

From Roy: name the disaster first. Decide the loss you cannot accept, write it down, and let it set the size of everything else.

From Kelly: whatever your conviction tells you to bet, bet half. The cost of betting too little is slow. The cost of betting too much is permanent.

Gala: you will meet many people who know exactly what to buy. The rare ones are the people who know how much. Stay close to those.