Modern portfolio theory

There are two irrefutable realities when it comes to investing money. The first is that each of us has a definite investment time horizon whether we are cognizant of it or not. We might be saving for a comfortable retirement forty years hence, or we may be saving for the college education of a child, which will commence in a few years.

The second verity of investing in assets other than savings accounts or certificates of deposit is that with the prospect of greater future investment growth comes the inevitable specter of risk. Investing in the stock market, for example, carries with it the fact that the value of our investment account might decrease.

Stock market returns can fluctuate dramatically from year to year, but over the long haul, investing in the stock market has generated very good returns. The question that each investor must answer personally is: how much risk am I willing to assume in my stock portfolio, or mutual fund, or whatever?

The notion of risk should be linked with our investment time horizon. If we have 30-40 years in which to invest our money, we should be willing to accept higher levels of risk in our investments, since we have “time” to recover from bear market downturns. But, at the same time, our willingness to accept more risk should result in the very real possibility of higher rates of return over our time horizon.

The time-honored axiom for how much of your retirement investment fund should be in equity-based investments was to subtract your age from 100 and use that remainder is the proper percentage of equities.

That methodology has been updated, and now the more appropriate method is to subtract your age from 120 and use that remainder. So, even if you are 70, as much as 50% of your retirement account investments should be in equities.

One of the ways that risk can be reduced is through diversification of our stock portfolios. If we own a stock that might go down in value if interest rates rise, we can purchase another stock that should go up in value if rates rise. In so doing, we have diversified our portfolio (rather simplistically to be sure) and reduced the “interest rate” risk. Diversifying in this way comes about when we choose what are known as “non-correlated” assets in our portfolio. Investing in non-correlated assets is a method for reducing risk.

The notion was first promulgated in a doctoral dissertation by Harry Markowitz, a Ph.D. candidate at the University of Chicago. Parts of his paper were later published in the Journal of Finance in 1952.

Dr. Markowitz was subsequently awarded the Nobel Prize in Economics in 1990.

What he posited was that investors should focus on the risk vs. reward of one’s entire portfolio, rather than simply purchasing individual stocks that have attractive risk/reward characteristics.

Markowitz developed a model, known as the efficient frontier, which shows investors the best possible return they can expect from their portfolios, given the level of risk that they are willing to accept.

The results of Markowitz’s work changed the investment world forever and paved the way for the development of mutual funds, indexed-based funds, as well as ETF’s. All these investment vehicles incorporate diversification to a greater or less degree and may be tailored to incorporate the amount of risk that the investor is comfortable with.

As an interesting aside, who would have imagined that the S&P 500 Stock Index would be up over 16% as it is at this writing? Personally, I was worried about the profligate spending that has occurred thus far in the year. However, the driver for the market has apparently been growth in economy, and that growth is continuing and is expected to be up 6% over 2020. Amazing.

This article originally appeared on Aiken Standard.


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