“In an effort to give our clients a look under the hood of our firm, please see the first write up of our series on risk and return from our financial analyst and investment committee member Griffin Sheehy.” – Mark Shone CFP®
Diversification and the Efficient Frontier
As previously mentioned, Harry Markowitz and William Sharpe gained prestige for their work in the areas of Modern Portfolio Theory and the Capital Asset Pricing Model (CAPM). Not previously mentioned however, is that they both won the Nobel Prize in 1990 for their contributions to the field of finance. This underscores the importance of these topics and being familiar with them. It’s these founding principles that tell us the fundamental reasons of why we diversify both across asset classes and within asset classes. The graphical representation of their work is also famous because it shows the rates of return and standard deviations of a collection of securities and for all portfolios you can get by allocating among them. The result is a region under a positive sloping curve where all of these possible portfolios exist. Markowitz called this curve the Efficient Frontier and it looks like this:
Assuming that investors are rational, we can confidently say that the ideal place to be is in a portfolio directly on the curve. Being directly on the curve can be interpreted as having successfully maximized returns per unit of risk taken. This is the first important caveat because this is where the best portfolios are found. Take a look again at the graph and notice the shape of it. Sounds dumb to say but it’s curved. Why is this the second important caveat? It’s actually the key to why we diversify portfolios simply because the relationship between the underlying returns of securities isn’t perfectly linear. To illustrate this, let’s look at a very basic portfolio consisting of only two securities and imagine a 50/50 split between the two.
If we assume the performance of these two securities doesn’t perfectly line up with one another, for example if one is having a stellar year and the other is also having a stellar year but the degrees to which they are don’t perfectly line up, then the standard deviation of the 50/50 portfolio will be less than the average of the two securities’ separate standard deviations. This is HUGE. This makes the case for why we diversify because by stretching that portfolio to the left and onto the curve itself, we are maximizing returns. The graph tells us that we’d be getting the same return while taking less risk to do so. If we look at statistics and why this is the case, the reason is due to lack of covariance. In finance this means that the less the covariance between our two securities (i.e. the less their performance lines up) the lower the standard deviation will be for a portfolio combining them. In fact, the ideal would be to find two securities that have a negative covariance, meaning that the performance of one is the opposite of the other or when one has a gangbuster year and the other craters. This concept is why we include multiple asset classes of all varying degrees of correlation to one another (covariance is a measure of correlation) and provides the case specifically for investing in fixed income and alternatives in conjunction with stocks. Fixed income typically has low or no correlation to that of equities and it also tends to have lower standard deviation over the long run. Depending on the goals of the portfolio, alternative investments can be structured in such a way they have varying levels of correlation to the stock market. They can be positively correlated, have low or no correlation, and be negatively correlated. The reason for having negatively correlated assets is for risk hedging and this is the reason why “Hedge Funds” have become so popular in recent years.
Griffin Sheehy, Financial Analyst