Harry Markowitz invented the wheel for portfolio construction and management, and that's no exaggeration. Modern portfolio theory (MPT), whose core principle says clients should select and balance uncorrelated investments to mitigate risk-and which is the conceptual underpinning for modern investing, is his brainchild.

Markowitz is fond of quoting Albert Einstein's aphorism, "a theoretical physicist is ... a philosopher in workingman's clothes." "I am a philosopher," he says. "I'm interested in what we know and how we know it." In terms of his practical legacy, Markowitz says, simply, he hopes he has successfully described how and when his investment management techniques should be used.

Those techniques are based on three foundational concepts: asset allocation, mean variance analysis and the optimized portfolio. Markowitz, a 1990 Nobel laureate and adjunct professor of finance at the University of California, San Diego, first introduced the idea of MPT in 1952-when he published his paper, "Portfolio Selection," which posited that investors should consider a security's impact on the entire portfolio, and not its singular merits alone.

Markowitz also developed a quantitative process, called mean variance analysis, to help investors figure out how to choose the most complementary securities for a portfolio. It calls for analysts to estimate the portfolio components' future returns, correlations and standard deviations, which are then combined to derive an optimal balance of risk and return. That move alone made the portfolio construction process more quantitative and seemingly, more objective (although it is based on projections, which can be flawed, as critics point out). The mathematical model is so enduring that all financial planners who sit for the certified financial planner certification (CFP) exam have to learn it.

Finally, Markowitz introduced the concept of an optimized portfolio, the idea that investments can and should reflect the best balance of risks and rewards for clients, given the current investing environment, their risk tolerance and their financial circumstances. "That is his genius idea, the secret sauce of MPT," says Ken Solow, founding partner and chief investment officer at Columbia, Md.-based Pinnacle Investment Group. "The idea that there is an efficient frontier, an efficient portfolio-we are never going to get past that."

His hypothesis was first published in 1952 in the Journal of Finance. Industry professionals credit his writings with spinning off other major ideas in economics, including accounting for risk and savings in a portfolio model. He is also credited with planting the seeds of behavioral finance.

IN THE BEGINNING

It all started when Markowitz was a doctoral student in economics at the University of Chicago. He was waiting for his academic advisor and struck up a conversation with an advisor-a stockbroker, actually-who suggested he look into applying mathematical concepts to the equity markets.

Markowitz looked up John Burr Williams' article, "Theory of Investment Value," which said the value of a stock should be equal to the present value of its future dividends. He wanted to add risk to the mix as well as value. Since investors instinctively bought more than one stock as a way to reduce risk, Markowitz thought there ought to be a way to measure risk and return differences among individual securities, and in a larger sense, covariance in a portfolio.

That thought process all unfolded one afternoon "in a flash," Markowitz says today. But it took him several days to construct an algorithm to express it.

Markowitz went to work for the Rand Corp., the nonpartisan think tank, in 1952 and developed the technical underpinnings of MPT in his spare time. The University of Chicago awarded him a PhD in 1954. "I asked myself, 'What problem is interesting enough for me to spend my quiet time thinking through?' That's me," he says.

MPT UNDER FIRE

Although no other quantitative portfolio theory has come along to knock MPT from its pinnacle, it frequently comes under attack as being outmoded. Most recently, during the market collapse of 2008, investors and advisors complained that diversification had let them down and did not sufficiently protect them from losses.

Defenders of MPT make several arguments on its behalf. One is that although MPT did not completely protect people while the market tanked, it did help on the way back up: Various asset classes rebounded at different rates. A second argument is that owing to the difficulty of calculating the various elements of Markowitz's algorithm, experts mechanistically inserted historical data, and thereby underestimated the risk of unexpected events. Others point out that while most asset classes declined during the downturn, U.S. government bonds did not-in fact, they rose in value-so those investors who had allocated funds to government bonds were protected from the worst of the downturn.