Last updated on October 5th, 2021
Last updated on October 5th, 2021 at 06:51 pm
It is a mistake for consumers and even investment managers to question the wisdom of diversifying amongst many asset classes. We have heard “advisors” say, “oh I don’t believe in modern portfolio theory”. Every time we hear that we find out that advisor has not been adequately educated in modern portfolio theory and does not understand the science and mathematics behind it. Yet people continue to use them because the advisor speaks with authority, is an employee of a known brand or simply has built a reputation. If an advisor does not have a CFA or a PhD, they probably have not studied the virtues of modern portfolio theory, and the latest research published in scientific journals. Using MPT to assist in properly devising a diversified portfolio is discounted by too many people in the field. Hopefully, more and more consumers will work with someone who has this knowledge.
Diversification amongst asset classes goes beyond just not putting all your eggs in one basket. It involves identifying asset classes with different patterns of behavior so that they bolster each other at different times. The economists have demonstrated that it is “the only free lunch in investing.”
MODERN PORTFOLIO THEORY
As an investment professional designs, a framework, the blueprint for a portfolio, statistics are key. Modern Portfolio theory is based on the mathematics of statistics. MPT was first introduced by a noble winning economist named Harry Markowitz who wrote a seminal paper in 1952. Harry Markowitz, Nobel Prize co-recipient for Modern Portfolio Theory and the Capital Asset Pricing Model, published “Portfolio Selection” in The Journal of Finance during 1952. In his original paper he illustrated the value of his theory using only two different investments. He introduced the idea of combining asset classes which operated differently in different economic conditions (the technical term for this is called being negatively correlated). The two different assets always performed differently but by adding them together the theory showed we can optimize the combined performance getting a much smoother ride (with a lower standard deviation and a lower volatility drag.
MPT was a breakthrough and it has allowed us to create efficient portfolios by combining less correlated assets and to manage the risk/return trade off.
ASSET CLASSES
Asset classes are groups of investments that have similar characteristics, serve a similar purpose, and behave in a similar manner. For example, face book and Microsoft are two stocks which belong in the large cap growth asset class. They behave very similarly. Let us try thinking of it a different way. Let us say you owned a booth at the farmers market and in your booth, you sold one single product representing one single asset class, sunglasses. Most of the year you achieved tremendous sales but what happens on rainy days? Nobody wants your sunglasses. On those days you pay for the booth, but your revenue does not even cover costs. This is not good way to create steady cashflow! What if you decide to get rid of some of your sun glass inventory and offer a second product? What should you offer? Well, how about umbrellas? We can analyze historical weather patterns and future forecasts to determine the optimum number of umbrellas and sunglasses we should hold. (For example, if you discover that 10% of the days are rainy and 90% sunny and you make twice as much on umbrellas as sunglasses, you may want to create some ratio to decide how much of each you should have in your limited space to help smooth out your income, perhaps keep 20% of your inventory as umbrellas). If you do it right, you should be able to maintain an optimum amount of revenue. This dramatically oversimplified example is exactly what we do when we mix and match assets in an “efficient” portfolio.
While we use many more asset classes than we mentioned in our simple example, good diversification might include at minimum the following asset classes:
- Large Cap Domestic Stock
- Small Cap Domestic Stock
- Large Cap International Stock
- Small Cap International Stock
- Real Estate (REITs)
- Convertible Bonds
- Natural Resources
- Domestic Bonds
Over the past 20 years (2000-2020) investing $100 in each of these asset classes separately would have resulted in different levels of wealth. Notice that if you invested only in the S&P you would have close to $400 but if you took it all and invested in International Small Cap stocks you would have over double the amount, almost $900.
Since we do not have a crystal ball, we would never recommend you put all your money into small cap international stock. You may notice by this graph that it is more volatile than the S&P. However, we would recommend you hold some of your portfolio in this asset class.
THE THEORY IN REAL LIFE
There are three main reasons why the wisdom behind Modern Portfolio Theory is questioned. Often the theory is questioned when the US stock market outperforms as it has in recent years but as you can see from the previous chart, the recent S&P returns cannot overcome the cumulative effect of the full twenty years. Due to “recency bias” a behavioral mistake, investors seem to forget the danger of putting all your money in one single asset class. Have the financial downturns experienced in the 2001-2002 and 2007-2009 escaped everyone’s memory[1]? It is important to recognize that these were not one-off experiences, and we will experience another bear market in our future. And do not think you can time it because you cannot (unless you happen to be lucky). Professionals know it is hubris (another behavioral bias: “overconfidence”) to think you can time the market.
The other reason why investors question Modern Portfolio Theory is that they do not understand it. Some people still think a 60/40 portfolio (which stands for 60% S&P stocks and 40% bonds) is a diversified portfolio. While it does include two separate asset classes it does not represent a truly diversified portfolio since it lacks other major diversifiers. Notice the chart below (Domestic is Large and Small, Global include International Large and Small, each next portfolio introduces another alternative asset class). The black line represents the full use of all asset classes, while the pink is a 60/40 which while less volatile, produced a similar result as investing in the S&P.
Now the portfolios in this last graph are evenly divided into the 8 asset classes but with statistical methods professional managers can create a mix that is even more efficient in terms of return and risk. This requires a full understanding a statistical methods and modeling which are unfortunately not required to be an investment manager. This regrettable omission is why many investment managers are not properly equipped to manage portfolios yet since it is not required, they do not even realize it.
The bottom line: Diversification is far from dead.
[1] The total return for the S&P 500 was -10% from 12/31/1999 through 12/31/2009, one of the poorer performing asset classes over the period.
