Red-Blooded Risk: The Secret History of Wall Street

Harry

Sixty years ago, an economics graduate student named Harry Markowitz sat in the University of Chicago library trying to come up with a dissertation topic. He was reading an analysis of stock prices, and mused on the question, “Why don't investors put all their money in whichever stock seems best?” He hit on an answer: “Because that would be too risky.” He worked out a system in which investors try to maximize expected return and minimize risk. This led to the development of modern portfolio theory (MPT), which has had extraordinary influence on the financial system (although Harry's dissertation chairman, Milton Friedman, is said to have observed that it was “nice work, but not economics”).

Modern portfolio theory was a major advance, but suppose Harry had known Kelly, who was developing his ideas around the same time. Harry might have answered the question differently: “Because buying one stock virtually guarantees doing worse than buying a larger portfolio. It's not riskier; it's just worse.”

I want to laser in on the difference here, because it's crucial for this chapter and this book, and it's not well understood except by risk managers. Let's say you look at all the available stocks and find the single best bet, in the sense of having the highest expected return. Let's say it's a little drug company whose stock will jump from $10 to $100 if it gets a favorable Food and Drug Administration (FDA) ruling, which it has a 20 percent chance of getting. If the company gets ...