Chapter 8: Harry Markowitz: “You Have a Little World”

Ø Markowitz has lost faith in what he terms the traditional neoclassical “equilibrium models.” These models, he claims, “MAKE UNREALISTIC – ABSURD – ASSUMPTIONS ABOUT THE ACTORS”

Ø Furthermore, at a time when the world changes so rapidly and the markets are so dynamic, the equilibrium at the foundation of Capital Ideas will never come about or will stand still for too short a time to matter.

Ø You can look at stock prices swinging up and down every day, but what you observe reveals nothing about what is going on under the surface, such as the degree to which investors are succumbing to the overconfidence and loss aversion featured in Behavioral Finance.

Ø Markowitz believes none of this can be accomplished by modeling. Nor can you accomplish it by just looking at stock prices and trying to figure out what drives them.

Ø Markowitz: “However, CAPM should be taught. It is like studying the motion of objects on Earth under the assumption that the Earth has no air. The calculations and results are much simpler if this assumption is made. But at some point, the obvious fact that on Earth, cannonballs and feathers do not fall at the same rate should be noted and explained… Similarly, at some point, the finance student should be shown the effect of replacing [unlimited borrowing and short selling] with more realistic constraints and the “so what” should be explained.”