Sunday, November 16, 2008
Harry Markowitz Speaks
"Our current economic crisis arose from an imbalance of risk and return in portfolios of mortgage-backed and other debt securities, so it seems timely to ask the father of modern finance what went wrong and what to do about it. ... The bad news is that bailouts to restore liquidity aren't addressing the real problem. ... [Financial engineers] violated the first principle of his portfolio theory. 'Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero,' he says in an interview. 'But financial engineers should know that's not true of a portfolio of correlated risks.' ... He draws the line between his portfolio theory and its later misapplication. 'Not all financial engineering is always bad,' he says, 'but the layers of financially engineered products of recent years, combined with high levels of leverage, have proved to be too much of a good thing.' ... 'Just as with all securities, the fundamental exercise of the analysis of the trade-off between risk and return has no shortcuts,' Mr. Markowitz says. 'Arbitrarily assigning expected returns absent an understanding of the risks of the securities is precisely how the economy arrived at this point.' ... Also, since 'financial engineers seem to get their necks chopped off periodically,' they shouldn't get bailed out when it happens", Gordon Crovitz interview with Harry Markowitz at the WSJ, 3 November 2008.
Neck chopping, I love it. I wonder how much Goldman Sachs (GSG) charges to rent its CNC guillotine for this purpose? Properly marketed, CNC guillotine rentals could become GSG's biggest profit center.