Searching for Alpha

The Equation that Changed the Investment World

For all practical purposes, the modern investment world was born when Henry Markowitz, a student at the University of Chicago, challenged then-accepted theories in his doctoral dissertation. Starting with John Burr Williams’ 1937 Theory of Investment Value, Markowitz came to some startling conclusions. The definitive market theory at the time came from Williams, who said the wise investor should buy only securities that trade at a price far below their true value, hold them and profit from a steadily rising dividend stream as the companies begin to prosper. Markowitz differed. He told investors to be as concerned with risk as with return. He developed a way to quantify risk and to differentiate the portion of return that represents a manager’s skill from the portion that represents the market’s direction. This value-added component of the total profit came to be called "alpha."

Markowitz developed the portfolio concept, emphasizing buying groups of securities instead of picking stocks. He thought the rational investor would rather maximize expected utility (return in relation to risk tolerance) than maximize return with...