Following the bear market of the 1970s, the investment industry as a whole went into crisis mode. Up until then portfolios had been chosen purely on the merits of each stock, with no strategic allocation or any kind of portfolio management. As a result of the great losses suffered, risk management suddenly became very important to Wall Street investors.

In 1952 an article appeared in The Journal of Finance entitled "Portfolio Selection" by Harry Markowitz, a graduate student at the University of Chicago. This article was quite short by academic standards, only 14 pages in total of which 10 pages were all graphs and pictures, yet today this article is credited with being the foundation of modern finance.

In Markowitz's view, only a short article was needed to explain his rather simple concept, that risk and return are directly linked. As an economist, he hoped to quantify this relationship between the two in a statistical manner, and thus determine the optimal levels of risk one would need to adopt for various levels of return. His paper was designed to establish by weight of statistical evidence that no investor can achieve above average gains without assuming above average risk.

Markowitz devised what he called the efficient frontier, a graph charting the most efficient means to returns by adopting a certain risk. Points lying on a graph below the efficient frontier, which plotted return on the y-axis and risk on the x-axis, are said to be inefficient, as they imply that excessive risk has been adopted for the return that is targeted. The most efficient portfolio lies somewhere on the curve, a negatively sloped arc, and shows the ideal amount of risk to be adopted by targeting a certain return.

So the risk measure adopted was the variance of a stock, another statistical measure for volatility. What variance couldn't tell us though, was the risk of an entire portfolio, the average of a series of variances is not a useful measure for portfolio risk. What Markowitz suggested, now regarded as his greatest achievement, was to adopt covariance as a measure of portfolio risk, based on the existing formula for the variance of a weighted sum. Covariance measures the correlations of a group of stocks, when two stocks have high covariance it means their prices move together in step, when covariance is low the stock trend in opposite directions. To Markowitz, the risk of a portfolio is not the variance of individual stocks, but the covariance of the holdings. The key was to adopt a portfolio with the lowest possible covariance, thus eliminating the risk that a single event could drive down all investments at the same time. The formula is an argument for diversification. A portfolio of highly risky shares could have a low overall risk if their effects were to move in opposite directions.

The book he wrote in 1959 and his original paper, were to all intents and purposes completely ignored by Wall Street.

About 10 years after the paper, Markowitz was approached by a PhD student called Bill Sharpe for advice on his dissertation topic. Markowitz told Sharpe of his work with the need for estimating all those covariances and then Sharpe returned to UCLA. The next year Sharpe's dissertation was published: "A Simplified Model of Portfolio Analysis", while founded in Markowitz's ideas the paper suggested a means of eliminating the need for all those covariance calculations. Sharpe's model tied the risks of all securities to some common base factor, which could be a stock index or some major economic variable such as the GNP. This method was far less computationally cumbersome than Markowitz's approach.

To Sharpe the most important factor that influences stock prices is the market itself. Volatility was measured by calculating the correlation of each stock to the relevant index. The measure of volatility he adopted was called the beta factor. A beta of one implies movement in unison, a beta of two implied a stock that moved with twice the speed of the market, and if a stock was more steady than the market the beta was less than one. A low risk portfolio had a low beta, a high risk portfolio had a high beta.

A year later, Sharpe introduced what he called the Capital Asset Pricing Model (CAPM), an extension of his single-factor model for composing efficient portfolios. In the CAPM, stocks carry two distinct risk, one is the risk of being in the market (systemic risk), this is beta and cannot be diversified away. The unsystemic risk, or risk of each stock can be diversified away by adding more stocks to the portfolio.

A logical extension of the CAPM is that the efficient portfolio is the market, no other portfolio can deliver the same returns without much greater risk, no portfolio can adopt lower risk and maintain the same returns.

A third element that combined with CAPM was the efficient market hypothesis, a development usually credited to the University of Chigaco assistant professor of finance Eugene Fama, though others such as Paul Samuelson at MIT also get credit.

Fama's PhD dissertation, "The Behaviour of Stock Prices", was published in The Journal of Business in 1963 and excerpted later in The Financial Analysts Journal and The Institutional Investor. The efficient market hypothesis had arrived on Wall Street, and quickly became the dominant theory about stock pricing, where it has remained until now.

It is impossible to test the efficient market hypothesis empirically, the only way of disproving it would be to show that certain groups of investors are able to consistently outperform beat the market, as Warren Buffett had not at that time made a big name for himself, and ignoring Ben Graham as best they could, Wall Street accepted the hypothesis completely.

Portfolio theory was developed throughout the 50s and 60s as the pieces fell into place, but it wasn't until after the debacle of the 1973-74 bear market that it finally became a part of the fabric of Wall Street being used by fund managers everywhere. This was the start of academia becoming the new gurus of Wall Street.