Part 2: Modern Portfolio Theory

Modern Portfolio Theory is another very important bit of research. A man named Harry Markowitz began working on this theory back in the 1950s. His goal was to figure out how to optimize the relationship between risk and reward in investing. That sounds complicated just reading it back to myself, but it does make sense, in fact, Markowitz received the Nobel Prize in 1990 for his work. A couple of quick definitions before we jump in: 1) risk in investing means volatility, how much a stock, or class of stocks, can move up or down in a year, usually referred to as standard deviation; 2) reward is a little more obvious, it’s the expected/historical rate of return for a class of stocks; 3) a class of stocks is called an ‘asset class’ (an example of an asset class would be large growth companies, or small companies, or small international companies, basically a sector of the market).

Risk and reward are two easily measurable characteristics of a stock or an asset class. Different asset classes obviously behave differently, they each have unique expected risks and rewards; the important thing to remember is that they also respond to market conditions differently, they don’t all move the same way at the same time, you can say they ‘correlate’ to each other differently. Harry Markowitz wanted to figure out how the risk and reward expectation of these different asset classes could be helpful to investors. His studies led him to the idea of an ‘efficient frontier.’

Since we can measure risk and reward year by year going backward, we can compare how the different asset classes have moved relative to each other, we can see how they’re correlated. Using a lot of math (Markowitz created an algorithm before algorithms were cool), Markowitz determined that owning different asset classes could reduce the overall risk of your portfolio while maintaining a great return. Since asset classes don’t always move the same way, one could go up while the other stays flat, or one could be going down while the other goes up. Say there’s a market downturn and you own a bunch of different asset classes, not all of them are going to decrease by 50%, some will remain flat, some will go down 20%, some might even go up a little bit. Overall, your portfolio will lose a fraction of what it might have lost if you were invested in one asset class, or worse, in one stock. By spreading the risk around through the different asset classes, you can actually achieve a better return with less risk. You’ll never be able to erase all risk in your portfolio, some years the account will go down, but you can dramatically reduce large swings using diversification.

So diversification is your friend. But Markowitz didn’t just determine that diversification is helpful, he also determined that there’s a mathematically ideal way to organize your investments to achieve the maximum amount of return for a given level of risk. Here’s a helpful picture to show how the Efficient Frontier works:

Every portfolio has a risk level based on how the portfolio is diversified. The question is, how does the diversification of your portfolio stack up against the Efficient Frontier? Unfortunately, the vast majority of portfolios haven’t accounted for the Efficient Frontier. Investors are routinely exposed to more risk than their returns warrant. An actively managed account isn’t even in the ballpark, the risk associated with those accounts are off the charts. But even a portfolio filled with passive index funds typically falls short, they routinely shade towards the Large Growth companies asset class because it’s cheaper to own, but it offers less return for the risk it demands. The key is to be broadly diversified with an ideal amount distributed between each different asset class. It’s an efficiency game, there are more returns and less risk to be had when the portfolio is organized and diversified the right way. We can actually look at any portfolio and see where it lands on the efficient frontier based on the stocks and asset classes it holds.

Here’s the basic point, and what you can take away from all this: diversification is the investor’s friend, and optimized diversification is the investor’s best friend. Make sure you know how your portfolio measures up to the Efficient Frontier.

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