Reflections on Portfolio Insurance, Portfolio Theory, and Market Simulation with Harry Markowitz

Abstract

In this paper, we describe some of the areas in which we have been fortunate to work with Harry Markowitzfields in which he was either the originator or was a major developmental force. These include portfolio insurance, portfolio theory, and market simulation.With regard to portfolio insurance, in the years leading up to the crash of October 1987, this strategy was very much in vogue, and we warned that it had the potential to destabilize markets. We believed that portfolio insurance was a major cause of the crash, and we wrote a book on the topic. Harry liked the book, and wrote its foreword, which in his subtle and piercing way makes the distinction between portfolio insurance and portfolio theory and their effects on financial markets.With regard to portfolio theory, we knew that Harry was not only a portfolio theorist, but was also putting his theories into practice, managing a portfolio at Daiwa Securities. We discovered that Harrys expected return estimation procedures used some of our ideas, as we employed his in our portfolio optimization. As our relationship with Harry grew, we worked on finding computationally efficient ways to compute optimal portfolios that included short positions. This interest lead to the development of theorems regarding the conditions under which standard efficient algorithms could be applied to the long-short problem.With regard to market simulation, Harry is a leading figure, having created the simulation language SimScript. We were very interested in studying the behavior of financial markets in response to various stimuli, but models that could simulate realistic markets were not available. Thus, we teamed up with Harry to create the Jacobs Levy Markowitz Simulator (JLMSim).