Three Wise Men of Finance

Their insights into the links between risk and return revolutionized investing forever
As part of its anniversary celebration, BusinessWeek is presenting a series of weekly profiles of the greatest innovators of the past 75 years. Some made their mark in science or technology; others in management, finance, marketing, or government. In late September, 2004, BusinessWeek will publish a special commemorative issue on Innovation.

If you've ever put money in an index mutual fund, you can thank three economists -- Harry Markowitz, William Sharpe, and the late Merton Miller. Such funds are the best-known application of research they did in the 1950s and '60s. Their work won them the Nobel prize for economics in 1990 and changed the way

investors and managers think about markets, money management, and securities design. Key concepts in investing and corporate finance that are today accepted as obvious can be traced back to their articles in scholarly journals -- everything from the existence of a systematic trade-off between risk and return, to the concept that markets are efficient.

Markowitz, a self-described nerd whose father was a Chicago grocer, set the ball rolling. In 1952, the University of Chicago economist published a 14-page paper called "Portfolio Selection." At its heart was what Peter Bernstein, dean of financial economists, called "the most famous insight in the history of modern finance" -- the idea of diversifying a portfolio of stocks in order to produce the maximum potential returns given the amount of risk an investor is prepared to take on. Of course, the notion of not putting all one's eggs in the same basket had been a truism for centuries. (It's mentioned in the Talmud and Shakespeare among other places.) Markowitz proved why this is so by explaining the fundamental trade-offs between risk and return and between asset concentration and diversification. Money managers around the world still follow his precepts daily.

Markowitz' early work sparked a long period of intellectual ferment. In the process, Markowitz, Sharpe, and Miller demolished many cherished Wall Street ideas. One example: that it's possible to beat the market consistently by savvy stock picking. Impossible, they said -- because thousands of investors collectively have factored everything that is known about stocks into current prices.

Sharpe, a charming if sometimes blunt computer whiz, devised the capital asset pricing model (CAPM), which quantified the idea that investors demand extra returns for taking on more risk. Souped-up versions of the CAPM are still used widely in business to guide investment decisions. Miller, a passionate defender of futures markets, developed, with Franco Modigliani, the MM Proposition. They showed that any company's worth depends on its earning power rather than its book value. So, if there's a tax break on interest payments, savvy companies should favor debt over equity. That insight was a real shocker to a Wall Street steeped in the cult of the equity. It provided the intellectual heft that led to the surge in the junk bond markets in the '70s. Leveraged buyout, anyone?

There were some failures. A few techniques developed from their ideas by Wall Street rocket scientists proved disastrous: So-called portfolio insurance was partly to blame for the 1987 stock market crash.

Now, a new generation of financial economists is challenging the work of Miller, Sharpe, and Markowitz, often improving on it. But it's the Nobel trio who helped turbocharge global capital markets.

By Christopher Farrell

Before it's here, it's on the Bloomberg Terminal.