From Markowitz to modern risk management

Abstract

Nobel Laureate Harry Markowitz is often referred to as the ‘founder of Modern portfolio theory’ and deservedly so given his enormous influence on the money management industry.1 However, it is my contention that he should also be referred to as the ‘founder of Modern Risk Management’ since his contributions to portfolio theory formed the basis for how risk is currently viewed and managed. More specifically, Markowitz argued that a portfolio of securities should be viewed through the lens of statistics where the probability distribution of its rate of return is evaluated in terms of its expected value and standard deviation. Since the ultimate selection of a portfolio involves the evaluation and management of risk as measured by standard deviation, it is clear that Markowitz's process of portfolio selection represents the birth of modern risk management whereby risk is quantified and controlled. In this paper, I will first, introduce value-at-risk as a measure of risk and how it relates to standard deviation, the risk measure at the heart of the model of Markowitz. Second, I will similarly introduce conditional value-at-risk (also known as expected shortfall) as a measure of risk and compare it with VaR. Third, I will briefly introduce stress testing as a supplemental means of controlling risk and will then present my conclusions.2