CapitalatWork

Diversification, the only “free lunch” in Financial Markets

It wasn’t until 1952 that it occurred to someone that risk could be defined with a number. In June 1952, the Journal of Finance published an article from an unknown 25-year-old graduate student at the University of Chicago. The title of the paper was “Portfolio Selection” and its author was Harry Markowitz. His paper was so innovative that it earned him a Nobel Prize in Economics in ... 1990.
Markowitz’s objective was to construct a portfolio for investors who consider expected return a desirable thing, and variance of return (or volatility) undesirable. He defined risk as volatility or variance. His basic insight was that the return of a diversified portfolio will be equal to the average rates of return of the individual holdings, and that at the same time, the volatility of the portfolio will be less than the average volatility of its individual holdings. The concept to link risk and return was nothing less than revolutionary.
The 1970’s were a dark period for investors. Until then, risk was in the gut, not in the numbers. Aggressive investors maximized return, conservative investors invested in bonds. Modern portfolio theory became accepted in the professional investment arena in the 1970’s.

Investing in a basket of stocks or in a basket of bonds allows an investor to lower the risk of his portfolio, without lowering the expected return. One of the great achievements of modern portfolio theory was to describe how a mix between stocks and bonds can alter the risk and return of a portfolio. As is shown in Figure 1, contrary to commonly held wisdom, a portfolio with 28% stocks and 72% bonds is less risky than a 100% bond portfolio and offers a higher return. The green line (the efficient frontier) displays the most efficient portfolios for all the different allocations (in %) between stocks and bonds.
Not all investors though, are prepared to take the risk of a mixed portfolio of stocks and bonds. Some investors want to have part of their assets risk-free. Nominal bonds and even cash though are not always risk-free. High inflation can lead to negative real returns, and a loss of purchasing power. In 1994 and 1999, bonds had negative returns. An investor who invested in nominal bonds in the 1970’s lost 50% of purchasing power during the decade. This is why at CapitalatWork we have always stressed that the only risk-free assets are inflation linked bonds (ILB’s). ILB’s are the only asset, that assure the investor of having a positive real rate of return. Combining the risk-free asset (ILB’s) with a mixed portfolio of stock and bonds offers the opportunity to investors to create a portfolio that delivers their required return, while minimizing risk.

Figure 1: Efficient Frontier

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One of the important criticisms on modern portfolio theory is the definition of risk. Is the risk of an investment really its volatility? Do we have to care about volatility if my investments go up? These are valid questions. At the heart of the definition of risk, lies the fact that human beings find it difficult to live with negative returns. And there, volatility comes into play. Because financial markets can fluctuate wildly over the span of a year, the possibility of a loss is high. This is especially true for stocks, and less so for bonds. This is shown on Figure 2. Important to realize is the fact that differences in volatility become smaller if you extend the investment period. Over longer time frames, the differences between bonds and stocks in volatility become minimal. Even stronger, in the past there have never been periods of 20 years being invested in the stock or bond market, that produced negative returns.

This is why the incorporation of the investment period becomes very important in deciding how to diversify your portfolio. As is shown on Figure 2, the famous efficient frontier that was described in the beginning of the article moves to the left (= less risk) when the holding period becomes longer. This means that risk to achieve the same returns becomes lower when your holding period becomes longer. The proportion of stocks in a diversified portfolio also becomes higher when the holding-period becomes longer.

Figure 2: Reduction of risk over time

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The only free lunch available in financial markets is diversification. The overwhelming evidence shows that combining a diversified basket of stocks with a diversified basket of bonds, and with a diversified basket of ILB’s, substantially reduces risk to achieve the same returns. Moreover, this proposition becomes even stronger, if you combine it with your holding period. “Time in the market” is more important than “timing the market” to achieve your financial goals.