Investments, Risk, and Return

What is risk?

Base jumpers. Photo: Christophe Michot. Souce: Wikipedia

In 1952 Harry Markowitz changed the world. By combining different assets he proved that a diversified portfolio would have a lower variance. His mathematical formula used the variance of asset prices around an average as a proxy for risk. It made sense at the time: the more asset prices jump around, the more nervous people get.

Markowitz’s work was ground-breaking. Never before had risk been so clearly linked to return, nor had its reduction via diversification been so elegantly quantified. Modern Portfolio Theory was born. The biggest problem Markowitz faced with his idea was classifying it: it wasn’t math; it wasn’t corporate finance; it wasn’t classical economics. Of course he got a Ph.D. in economics, and later won the Nobel Prize for his work.

Risk and Return of possible portfolios. Source: Wikipedia

But Markowitz had another problem. He didn’t have anything but a slide rule to calculate his numbers. He had to do all his math by hand. Variance is fairly simple to calculate, but most investors don’t think of risk as variance. For them, risk is the chance of losing money. It comes in two flavors: short-term and long-term.

Short-term risk is the risk of 9/11 or the Financial Crisis or the Asian Contagion: major events that impact the market but that we also get over and move on from in a couple years or so. Unless you have to sell when the market is down, your portfolio will recover. Diversification reduces short-term risk, precisely because that’s the kind of risk Markowitz was calculating with his slide-rule.

But long-term risk is the risk of hyperinflation or asset seizure or devastation–by war or natural disaster. It’s the kind of loss that Shakespeare or Solomon worried about. And the solution is similar: spread your assets out, because you don’t know what disaster may be waiting around the corner. But it’s not enough just to buy stock in different companies if a revolution is headed your way. To hedge that sort of risk, you need to think differently.

Apple “Think Different” Ad. Public Domain. Source: Wikipedia

It’s a mistake just to look at short-term fluctuations. Long-term issues are real. Investors need to be ready, just in case.

Douglas R. Tengdin, CFA

Chief Investment Officer