What’s the best way to put a portfolio together?
Photo Andrijko Z. Source: Wikipedia
Modern Portfolio Theory was born in 1952, when Harry Markowitz published his famous (and first) paper, “Portfolio Selection.” He won the Nobel Prize for his insight, which incorporated risk as a critical element of investment portfolio design. The key insight is that an asset’s risk shouldn’t be assessed in isolation, but in the context of how it contributes to a portfolio’s overall risk and return.
Return is easy to calculate. It’s just the weighted average of the returns of the assets in the portfolio. But risk is trickier. First we have to define it, then we have to measure it. For most people, risk is the likelihood that they will lose money. So short-term Treasury Bills have little risk, as do bank deposits less than the FDIC-insured maximum. On the other end of the scale, volatile assets – like small-cap stocks or commodities – are much more volatile. There’s a far greater probability that they will go down in price, just when you need them.
Small Cap stock return distribution. Source: Bloomberg
We can compute the probability of loss by calculating the variance of the returns. While no one worries about upside risk – the chance that a portfolio will do better than expected – the fact is that upside risk goes along with downside risk. But a portfolio’s risk isn’t just the average of all its constituents’ risk. You also need to consider how correlated those returns are. That was Markowitz’s key insight: by combining assets that weren’t perfectly correlated, investors could reduce their portfolios’ overall risk. So the three major elements that go into portfolio construction are return, risk, and correlation.
This is fairly simple when you just look at two assets. But the more assets you add, the more complex the math becomes. Still, the insight is intuitive – and profound. By assembling a portfolio of non-correlated assets, investors can have higher returns for a given level of risk – or lower risk, for a given level of returns. In fact, the insight was so novel back in the ‘50s that Markowitz almost didn’t get his Ph.D. for his dissertation – which became the basis of his Nobel Prize-winning contribution. One member of his thesis committee argued that his contribution wasn’t Economics, so they couldn’t award him a degree in Economics.
Efficient Frontier. Source: Wikipedia
It might not have been part of Economics back then, but it is now. Every investor should understand that not all risk is bad risk – depending how it fits in with the rest of your portfolio. The most important thing about diversification, though, is not to give up on an asset class just because it doesn’t seem up to scratch. Chances are it will turn around just after you sell it. Diversification works, but only if let it work.
Douglas R. Tengdin, CFA