Harry Markowitz, the renowned architect of Modern Portfolio Theory, recently passed away at the age of 95. In his honor, we reflect on his principles of diversification that continue to guide investors today, complemented by insightful quotes from Markowitz himself.
“Modern Portfolio Theory recommends diversifying with a balance of stocks, bonds, and cash that aligns with your risk tolerance.”
Markowitz’s influential paper, “Portfolio Selection,” published in the Journal of Finance in 1952, laid the groundwork for Modern Portfolio Theory (MPT), earning him a Nobel Prize.
MPT serves as a mathematical framework for optimizing investment selections to maximize overall returns while managing acceptable risk levels. While we’ll bypass the intricate mathematics, the foundational concepts continue to inform diversification strategies employed by wealth managers like Nutmeg.
At its core, MPT emphasizes the importance of asset correlation in enhancing portfolio diversification and decreasing the risk associated with achieving a particular return. A classic example of this is blending equities (generally considered a higher-risk asset class) with bonds.
Markowitz asserted that investment characteristics should not be evaluated in isolation; rather, they should be analyzed in relation to their impact on the overall risk and return of a portfolio. By prioritizing clients’ risk tolerance, wealth managers can construct well-balanced portfolios that optimize the risk-return spectrum among various assets.
However, it is essential to recognize that investing does not guarantee returns.
The Efficient Frontier
“Perhaps the most important role of a financial advisor is to position clients correctly on the efficient frontier within their portfolios.”
A pivotal aspect of Markowitz’s work with MPT is the concept of the efficient frontier. This concept graphically represents the best possible returns investors can expect from a portfolio based on the level of volatility they are willing to accept. The most efficient portfolios offer the highest expected returns for a given risk level.
The efficient frontier is illustrated in a chart that depicts various portfolios, plotting their potential returns against the risk taken (often assessed through standard deviation or volatility). The maximum returns are typically found in the top right corner, representing portfolios composed entirely of high-risk assets (for example, 100% equities). As you move left down the risk scale, lower-risk assets like government bonds are introduced into the mix.
Chart: Markowitz’s Efficient Frontier
Source: Nutmeg
The key takeaway, as recognized by Markowitz and successive generations of investors, is that investors can construct portfolios with diverse expected returns for a specific risk level. Conversely, for any given expected return, it’s possible to create portfolios with lower associated risks. Optimal portfolios that reside on the efficient frontier tend to exhibit higher diversification than sub-optimal portfolios, which are generally less diversified.
Diversification in Action
“Diversification is the only free lunch in investing.”
Diversification is a fundamental principle guiding portfolio management at Nutmeg. Each of our portfolios reflects risk levels and benchmarks, incorporating major asset classes like equities and bonds, along with their sub-asset classes.
There are many variables to consider; for instance, emerging market equities are historically considered riskier than equities from the UK or US, while corporate bonds carry higher default risks than government bonds.
Nutmeg’s strategic allocation framework analyzes over 25 years of historical data to evaluate how each asset class contributes to overall portfolio efficiency. Clients can explore detailed asset allocations within each portfolio style through the ‘Past Performance and Asset Allocation’ section of our investment portfolio pages (accessible via the ‘Asset Allocation’ tab).
For those interested in further understanding our approach to diversification and examples of failed concentrated strategies elsewhere, our blog, Investor Essentials: What is Diversification?, offers valuable insights. Additionally, those curious about prevailing correlations between equities and bonds may find our latest blog useful.
Thanks to pioneers like Harry Markowitz, investors have gained from decades of enhanced portfolio management research. At Nutmeg, we recognize the significance of diversification in our investment approach, providing clients with the best opportunities for long-term investment success.
Risk Warning
As with all forms of investing, your capital is at risk. The value of your Nutmeg portfolio may fluctuate, and you might receive less than your initial investment.
Let me know if you need any further adjustments or additional information!