Several weeks ago we did an article about the difference between shopping and investing where we discussed the danger in building a portfolio solely based on the merits of each of the funds. Sadly, this type of investing is common, even among professionals. It’s tempting to search for the highest rated or highest returning funds and simply add a little bit of each of the best ones to your portfolio. Unfortunately, this type of investing can be disastrous in the long run.
In 1952, economist Harry Markowitz introduced the concept of Modern Portfolio Theory which later won him a Nobel Prize in economics. The premise behind the theory is simple: a good portfolio will maximize returns while minimizing risk. When we build portfolios solely by purchasing the best returning funds, we may feel like we’re maximizing returns, but the problem is we’re looking at each of those funds on an individual basis and failing to consider how they work together (or fail to work together) to accomplish our goals. You can think of building a portfolio as a task similar to decorating your home. You could just go out and buy lots of nice things: a fur rug here, a marble sculpture there, a crystal chandelier, some fine curtains, gold candlesticks, etc. and fill your home with them. The problem is, those things may all be really nice, but they may not go together and your collection of really nice items may leave your home looking really tacky. Instead, you want to devise a plan and purchase pieces that work together. This is the core concept of modern portfolio theory: you want to maximize the return and minimize the risk for the total portfolio and you can’t do that unless you consider how the funds interact.
Key to this idea of interaction is what’s known in the statistical world as correlation. Correlation has to do with the relationship between two things. For example, two funds that both follow the S&P 500 will be highly correlated – meaning they will act almost exactly the same. Knowing that it wouldn’t make sense for you to include both of them in your portfolio because now you are paying twice as much to trade funds that basically do the same thing for your portfolio. Conversely, if you compare a bond fund and a stock fund you will find that they may have a low correlation meaning they aren’t related at all, or they might be negatively correlated meaning they move in opposite directions. In the instance of negative correlation, we would find that when one fund moves up, the other moves down and vice versa. This is very helpful in minimizing risk. Wouldn’t you rather have a portfolio that has some funds that go up when some funds go down as opposed to a portfolio where all of your funds fall at once? For many individuals, the answer is a resounding yes.
Over the next few weeks, we’ll dig a little deeper into the concept of Modern Portfolio Theory to help you better understand what makes a good portfolio and whether or not your advisor is doing his or her best to maximize your returns while minimizing risk. As always, if you find yourself scratching your head or simply wanting to learn more, please don’t hesitate to reach out. We’re happy to expand on the concepts.
Markowitz, H. “Portfolio Selection.” The Journal of Finance, vol. 7 issue 1 (1952). 77-91. Accessed October 16, 2016. http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1952.tb01525.x/full.