Balancing Act

The notion that investors should diversify their portfolios seems self-evident now. But when Harry Markowitz first proposed a systematic way to implement that strategy, the financial community scoffed and no less an economist than Milton Friedman was skeptical. Said he: "Harry, what's this? It's not mathematics; it's not economics; it's not finance."

Last week, more than 35 years later, the Swedish Academy awarded the Nobel Prize for Economics to Markowitz, a professor at the Baruch College of the City University of New York, and two colleagues who built upon his work. Sharing the honor were William Sharpe of Stanford University and Merton Miller of the University of Chicago.

Markowitz, 63, showed that investors fared best when they purchased a wide * range of stocks, bonds and other assets, because the risks in a diversified portfolio tended to offset one another. That insight made Markowitz the intellectual father of the mutual-fund industry. Sharpe, 56, demonstrated that the risks and rewards of holding an asset like stock are linked to its volatility in relation to the rest of the market. For example, highly volatile stocks are the biggest winners in bull markets but suffer the heaviest losses in downturns. Sharpe has cashed in on his insights, running an investment advisory firm whose clients include the pension funds for AT&T and the state of California.

Miller, 67, focused on corporate finance. In a 1958 paper that Miller co- wrote with Franco Modigliani, the 1985 Economics laureate, the two men showed that the overall value of a company was based on the cash flow that the firm generated. As the overleveraged 1980s have painfully borne out, companies with poor cash flow tend to wind up in bankruptcy.