Jul 20, 2018 | BEN WAITE
If you were to create the perfect investment, it would be one that gave you high returns for low risk. The reality of course, is that such a thing doesn’t exist!
Unsurprisingly, the subject of ‘risk and return’ has been a topic for many academics over the years, developing theories and strategies as to how you could structure the perfect investment. The most popular and successful being ‘Modern Portfolio Theory’, or MPT as it is known.
MPT originated from the work of US academic, Harry Markowitz, who introduced a whole new way of thinking about portfolio construction. In particular, MPT introduced the concept of ‘efficient’ or ‘diversified’ investment portfolios. MPT showed that by combining multiple investment holdings into a diversified portfolio, the overall risk will be lower, and the variability of returns will be reduced.
Markowitz’s major contribution was to outline a framework for diversification. He provided a procedure for evaluating different combinations of investment holdings and selecting the combinations which gave the optimal return for the level of risk taken.
This optimal relationship between risk and return is what Markowitz termed the ‘efficient frontier’. The ideal combination of investment holdings to maximise the reward for differing levels of risk, sits on this frontier. An inefficient investment portfolio would be one constructed off the frontier, as the graphic below shows:
An inefficient portfolio would likely generate a worse return, with a greater amount of risk.
Whilst Markowitz’s original research was completed in 1952, it’s been updated and developed since then and he was even awarded the Nobel Prize in Economics in 1990. His famous phrase, “diversification is the only free lunch in investing” will be around for a long time and his work remains to be the backbone of financial theory and practice.
When applying MPT to our model portfolios, we consider diversification at three different levels:
We also apply James Tobin’s “Separation Theorem”. Tobin stated that the most efficient portfolio available, is a globally diversified stock market based portfolio that sits at the optimum point of the efficient frontier, i.e. the point on the curve with the best set of risk/return characteristics. He then expanded his theory (as not everyone is comfortable with this level of risk), suggesting that investors should dilute this portfolio with lower risk investments, to create a portfolio that would be suitable for them.
Using these diversification principles, we’ve built a range of model portfolios that are appropriate for different risk profiles. Our growth asset mix, includes allocations to global stock markets as well as global property. We then have a defensive asset mix, which includes allocations to mainly short dated government bonds and index linked government bonds.
As to understanding the right mix of ‘growth’ and ‘defensive’ assets, that’s driven by a sound financial planning process initially. We then review each year, to ensure the mix remains appropriate for your risk profile, goals and objectives. We’ll go into this in further detail in the next chapter of our investment blogs, where we’ll cover our 4th guiding principle, ‘Focus on the investment mix’.
The value of investments and the income from them can go down as well as up, and you may get back less than you originally invested. Past performance is not a guide to the future. The investments described are not suitable for everyone. This content is not personalised investment advice, and Creaseys Wealth can take no responsibility for investment decisions you may make as a result of this information.
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