One of the more interesting ironies of history is that the man who laid the foundation for modern quantitative finance began his career as a Marxist revolutionary.
Jacob Marschak may not be a household name today, but he inspired a number of financial practitioners and thinkers, from Milton Friedman to Harry Markowitz, and his insights are now the backbone of trading strategies and computer algorithms worldwide.
Marschak was born to a Jewish family in Kiev, Ukraine, in 1898. He played a part in the Russian Revolution as a teenager, working as a Menshevik activist. The liberation of Ukraine from the czar’s Russian Empire vaunted Marschak into the position of labor minister of the short-lived independent state of Terek.
Within months, the state was absorbed by another region and then subsumed into the Soviet Union. A disillusioned Marschak fled to Germany, where he received training in the Austrian School of free-market economics. He hoped to make a permanent home in Germany, but when the Nazis came to power, the Jewish-radical-turned-Marxist-turned-Austrian-School-economist wisely left the country, moving first to England and then to the U.S., where he joined the New School in New York as part of an anti-fascist University in Exile.
Marschak was but one of a tide of theoretical financiers and economists who flowed into the U.S. as the Nazis came to power in Germany. Some of them gravitated toward the University of Chicago, including Marschak, who became director of the Cowles Commission, an innovative research institute founded by Alfred Cowles III. While there, Marschak inspired a generation of financial theorists who would become known as the “quants.”
Before the rise of the quantitative approach, finance was more an art than a science. Practitioners relied on instinct and experience, and theoreticians used rudimentary tools based on expected discounted net income to price securities. Yet there was a recognition that these approaches didn’t properly price uncertainty. And there was an appreciation that one shouldn’t put all eggs in a single basket.
In 1935, the British economist John Hicks (subsequently a Nobel Prize winner) noted that a prudent investor ought to place some assets in risky enterprises and the remainder in safer investments. Doing so could calibrate a portfolio to better match the investor’s tolerance of risk.
This observation was intuitively helpful, but it lacked theoretical guidance. Before an investor can hedge risk, a measure of risk must be created.
Marschak proposed a way to do so in his 1938 paper “Money and the Theory of Assets.” He observed that investors, by their nature, anticipate future production and prices. Yet while they try to assess the expected mean of future prices, they must also assess the probability of a range of possible future values and how they may be interrelated.
Marschak proposed that such expectations could be defined by two parameters: the mean and the coefficient of variation. He deemed the latter to be a measure of risk, which we continue to use today.
Physicists had for a century used this same methodology to describe means and probabilities. They had developed a way to calculate a mean (or expected) value based on the probabilities of the various possible future outcomes. This was called the first-moment calculation. They also developed a measure of variability by weighting the probability of the square of various outcomes compared with the mean. This second moment is our now-familiar calculation of variance.
Marschak reasoned that this same mean-variance technique could be applied to asset prices. But he took this natural extension still further: He recognized that there may be a statistical relationship between how one asset varies relative to another. This covariance would eventually act as the basis for the insight of one of Marschak’s best-known students, Harry Markowitz.
Markowitz had been intrigued with the Great Depression-era research of John Burr Williams, who developed the first systematic theory of discounted corporate cash flows. Under Marschak’s guidance, Markowitz realized that although the mean present value of future cash flows is important, so are their variances.
This mentor-mentee collaboration soon resulted in Markowitz’s thesis and seminal 1952 paper on modern portfolio theory in the Journal of Finance, titled “Portfolio Selection.” From that point, modern finance theory was born.
Marschak’s paper on money and the theory of assets -- and his other work on market rationality published while he was inspiring the thesis for a young Markowitz -- isn’t well-read among financial theorists or professionals today. However, a reader would easily recognize his analyses. The two-parameter mean-variance approach is now baked into every financial calculator, and into formulas ranging from Markowitz’s market-security line to William Sharpe’s capital-asset pricing model to the Black-Scholes-Merton option-pricing formula. Each of these fundamental formulas in finance assumes that the reward-risk trade-off can be described by only two parameters, just as Marschak proposed in 1938. Marschak’s academic descendants were later awarded Nobel Prizes for work that would have been impossible without him.
Marschak, the onetime radical, did indeed end up launching a revolution -- just not the one that Karl Marx had in mind.
(Colin Read is chairman of the finance department at the State University of New York, Plattsburgh. He is the author of the “Great Minds in Finance” series and other finance titles published by Palgrave MacMillan. The opinions expressed are his own.)
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