Playing with Fire? You Get Burned.

For those of you who have studied Finance and Investments, you are certainly familiar with the father of Modern Portfolio Theory, Harry M. Markowitz.  Mr. Markowitz earned the Nobel Prize in Economics for his recognition of the benefit of diversification in reducing risk in a given portfolio of securities.  In yesterday's Wall Street Journal, Mr. Markowitz was quoted on the role of financial engineers in today's financial crisis.   Below are his remarks.

"Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero," he says in an interview. "But financial engineers should know that's not true of a portfolio of correlated risks."

More specifically, Mr. Markowitz is referring to the financial engineers who created the mortgage-backed securities using tranches of various types of mortgages and touting their diversification benefits.  What they failed to mention, was the fact that risk is not mitigated when using similar types of securities with correlated returns.  Not only is risk not mitigated, it is exacerbated like throwing gasoline on a fire.  I guess those involved in creating this mess either fell asleep in class the day Modern Portfolio Theory was discussed or simply sold a pack of lies.  In either case, they were playing with fire and a whole bunch of people got burned.