Risk & Return – Part 1
April 4, 2019
2019 First Quarter Investment Market Report
April 10, 2019

Risk & Return – Part 2

“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

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Mark Shone CFPMark Shone, CFP

Phone: 925.472.0874
Mobile: 925-209-3771
Fax: 925-472-0884
E-mail: mshone@shoneassetmgmt.com

Mark Shone, CFP®, founder of Shone Asset Management LLC, is responsible for all aspects of Financial Planning and Asset Management at Shone Asset Management and works directly with clients of the firm. He has been in the business since 1988 and founded the firm in 2005 as a fee only financial planning and asset management business. Prior to founding Shone Asset Management, he was a Managing Director and Neuberger Berman and Lehman Brothers. Mark has a degree in Finance from California State University, Sacramento, competed his certificate in taxation at UCLA and completed a course of study at the Wharton School.

Mark enjoys helping families and clients map out the financial life they want to create and helping them by making smart decisions over time. He has extensive experience speaking on and guiding clients through topics such as retirement planning, preparing for the cost of education, investment allocation strategies, estate planning topics, insurance and behavioral finance. He is committed to helping clients maximize their full wealth potential.

In his spare time Mark enjoys golfing, is an avid sports fan and is a drummer for the band Stagefrite which plays cover songs from the 80’s to today.


Gail Markham

Director of Client Service

Gail has worked in the Financial Services industry since 1983; as a Bank Manager, and as an Investment Advisor as well as Compliance Manager for major Wall Street firms.  She is a graduate of the University of the Pacific.

Gail is a long time resident of the East Bay.  She lives in Walnut Creek with Will, her husband of 26 years.  She has two children, Jack & Kelly who are college students.

Gail enjoys golf, hiking, traveling, gardening, wine and college basketball.


Griffin Daniel Sheehy

I came on board with Shone Asset Management in 2016 and as Financial Associate, I provide support in the areas of investment planning, financial planning, and portfolio management. I am a graduate of Cal Poly San Luis Obispo’s Orfalea College of Business where I earned a Bachelor of Science of Quantitative Economics concentrated in Financial Management. Post-graduation, I went straight to work for Waddell & Reed, which is a large advisory firm that specializes in financial and investment planning. I started there in an assistant-type role until earning my Series 7 and Series 66 licenses and at that time promptly transitioned into an Advisor Associate role. Having those licenses allowed me to not only engage in full support on the client servicing side, but in the financial and investment planning process as well. This is where I learned just how critical developing, implementing, and constantly reviewing a solid all around plan is to the success of one’s financial goals. While in college, I interned at Northwestern Mutual in Sacramento where I earned my Insurance License and was educated in the value of managing the risk of unforeseen events in life. I also interned at a small commodities market research firm based in Petaluma, California called Streetwise Reports.

I am married and in my free time I enjoy outdoor activities with my beautiful wife like taking beach trips and hiking. I also enjoy playing sports in local leagues for baseball and basketball.