The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

CHAPTER 22

The Birth of Portfolio Theory: The Age of Covariance

Recall the absurd example of hijacking an airliner, asking for $1 billion, and having one chance in a thousand of getting away with it. On average you get $1 million. However, equating this with $1 million in cash is a clear commission of the Weak Form of the Flaw of Averages. Yet technically that’s what the academic literature in finance did until the mid-1950s. Let me take you back to the beginning. It’s 1955. The picture is black and white. The sound track crackles.

“Harry, you’ve got a problem.”

It is the voice of the renowned economist, Milton Friedman, and it’s not what the young Harry Markowitz wanted to hear at the oral exam for his doctoral dissertation.

“This is not economics,” Friedman went on. “It’s not business administration. It’s not mathematics.”

“It’s not literature,” quipped Jacob Marschak, the head of the dissertation committee.

No, it was not economics, business administration, mathematics, or literature. But it was the birth of modern portfolio theory, for which Markowitz would share the Nobel Prize decades later. The committee is to be forgiven for not immediately grasping the full import of his thesis. These were men of letters and equations. Harry, on the other hand, was a student of computers, who had used this infant technology to manage investments in ways unimaginable up to that time.

Risk Is the New Dimension

A few years earlier, as Markowitz was studying the academic literature on ...