Modern Portfolio Theory post image

In the Mutal Funds post I mentioned that one of the advantages of a mutual fund is diversification. In fact more often than not diversification is treated as some sort of panacea for risk. It is taken as an article of faith these days that to chase higher possible returns one accepts more risk. And that a broadly diversified portfolio is less risky than a narrowly focused one. But, back in 1952 when Harry Markowitz published his paper Portfolio Selection in the Journal of Finance this was an exciting insight. Enough so that he ended up with a Alfred Nobel Memorial Prize in Economic Sciences in 1990 out of the deal.

Why is risk so closely linked with reward? All investments carry risk. In an efficient market where all investors operate with the same knowledge each security is evaluated on its own merits. Lets consider a bond issued by a city. To determine if the bond is worth buying an investor would consider the interest rate it is paying and consider how likely the issuing city is to pay back the face value of the bond. A city with a dwindling population and associated tax revenue along with an already high debt load is a risky proposition. If another city with a growing population with the associated expanding tax revenue base and few debts is also offering a bond with a similar interest rate guess which bond is going to be bought up first. It just makes sense to bet on the faster horse rather than the one with a bum leg. So the struggling city would need to offer a higher interest rate to investors to entice them to purchase their bond rather than the growing city.

A portfolio is diversified when it is composed of securities that aren’t closely correlated. Correlated being a fancy way of saying they behave similarly. For example the things that affect an airlines business such as the price of fuel and the demand for the seats on their plane tend to affect all airlines. When the price of oil goes up all the airlines end up paying the new higher price. They do use option contracts to smooth the price and make their fuel costs easier to forecast but, rising fuel costs end up affecting all airlines eventually. The same goes for demand for their seats. The week of Thanksgiving is a big travel week here in the U.S. and this increased demand is felt by all the airlines at the same time. So airline stocks tend to be closely correlated as the things that affect one affect them all. A security like a bond issued by a company in consumer electronics business doesn’t really care one bit that there are a lot of people at the airport flying that week. So the bond and the airline stock are not closely correlated.

These concepts are so hallowed that it is hard to have a discussion about asset allocation without touching on these ideas. And why would you want to avoid them anyway since they work so well? My asset allocation is a result of my time horizon, risk tolerance, and financial goals. I accept just as much risk as I am comfortable with and maximize the expected return with that level of risk. Since I am in the asset accumulation phase and I don’t plan on needing to spend the assets in my nest egg for a few years so I tend to run fairly high on the risk side to hopefully capture the higher returns. And if the bottom drops out of the market it isn’t a big deal since I’m still accumulating and will just keep stashing it away.

To assemble a diversified portfolio that sits at the right place in the risk/reward spectrum I use a few tools. A broad market stock fund is my higher risk and higher reward component. A broad market bond fund is my lower risk and lower return component. I used to go in for international diversification but, international returns are becoming more closely correlated with U.S. returns. Many large U.S. companies have significant foreign operations making their stock an international stock in its own right. Since the expense ratio for a foreign fund tends to be so much higher than a domestic fund and I’m already getting some international exposure through the domestic fund I didn’t see the value in paying the higher fees. I have also not included REITs. The broad market stock fund already contains REITs and companies involved in real estate so adding a REIT to the portfolio would mean I was tilting towards real estate. This isn’t something I have any desire or reason to do. I have a broad market stock and a broad market bond fund and figure out how much I am comfortable having in stocks. Some folks will argue for 100% stocks other will recommend a 50/50 split between stocks and bonds. I started my working career in the depths of the great recession and even though I want to keep the possible return high and I’m willing to accept risk to do so I like to keep some dry powder around in the form of capital in bonds. I have the account set to automatically re-balance to my desired allocation. so when stocks do great some get sold off automatically to buy bonds and when stocks tank the account sells bonds to buy more stocks. So it automatically sells winners to purchase more losers which works out well.

The takeaways from MPT are:

  1. Risk and return are linked. With a chance for greater returns comes more risk.
  2. Diversification across securities that don’t rise and fall with each other reduces your portfolio’s risk overall.