Portfolio management is not a new art. In the 1950s, Harry Markowitz, at the University of Chicago, developed a model of portfolio construction based on the interactions of different asset classes with each other. What he found was that by mixing different asset classes you could actually reduce the risk of a portfolio while maintaining the same future expected return. These portfolios are known as efficient portfolios. While each particular asset class or individual security may be highly risky by itself, the interaction of these individually risky asset classes with each other matters more. Prior to his studies the emphasis on portfolio construction was to determine whether a stock was overpriced or underpriced and then to buy the underpriced stocks. Modern portfolio theory places the emphasis not on individual stocks but on the portfolio as a whole and how the components of the portfolio interact with each other.
What modern portfolio theory fails to explain is how much risk you ought to take. Which efficient portfolio is right for you? There are three broad ways to determine your risk capacity: ability, willingness, and need. Your ability to take risk depends on many factors, including your age, income, the size of your portfolio. Your willingness to take risk is purely psychological and answers the question “How much money can I lose and still sleep at night?” Your need to take risk depends on your lifestyle, your expenses, and your financial goals and is the most important factor in determining your asset allocation. While you may have a high ability and willingness to take risk, if your need to take risk is low, why risk it?
A landmark study published in 1986 looked at 91 pension plans over a ten year period and found that 94% of the variation in returns was explained by asset allocation, implying that market timing and selecting individual securities contributed very little to portfolio performance.
It is an undeniable truth that risk and return are directly related. Returns come from risk. They are like a marriage where divorce is not an option. In the context of stocks, asset allocation, determined by your individual risk capacity, ultimately means that not only are we purchasing businesses but we are also purchasing their underlying risk in the hopes of receiving a return. Now that we’ve established an “airway” for our portfolio via asset allocation, it’s time to make our portfolio “breathe.” Stay tuned next month, when I’ll focus on the “B” of investing.
Financial Terms and Concepts
A type of investment with unique risk characteristics (i.e. stocks, bonds and real estate)
The mix of different asset classes within your portfolio
Modern Portfolio Theory:
An economic theory which focuses on how investments interact with each other to form investment portfolios which maximize return for a particular level of risk or minimize risk for a particular level of return
A portfolio that provides the greatest expected return for a given level of risk, or equivalently, the lowest risk for a given expected return
An investment strategy which changes the types of investments based upon some prediction of a future event, such as a change in the economic cycle or market trends
Assets which are characterized by large price movements, such as stocks and hedge funds