In 1952 Harry Markowitz published a paper in the Journal of Finance that changed the world. He showed that by combining different assets the variance of the combined portfolio would be lower. 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.
But Markowitz had another problem. He didn’t have anything to help him calculate his numbers. He had to do all his math by hand. And most investors don’t think of risk as variance. To them, risk is the chance of losing money. And risk comes in two main 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 few years. Unless you have to sell at the bottom because you don’t have enough to live on, your assets 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 the author of Ecclesiastes was aware of. And the solution is similar: spread your assets out, because you don’t know what disaster is waiting around the corner.
It’s a mistake just to consider short-term fluctuations. Long-term issues are real. Investors need to be ready, just in case.
Douglas R. Tengdin, CFA
Chief Investment Officer