The Father of Modern Portfolio Theory Speaks

There is a collection of accepted learning in the field of financial economics known as Modern Portfolio Theory (MPT). MPT is so commonplace now that it is hard to believe that it was revolutionary 50 years ago. That was when a Phd student at the University of Chicago, Harry Markowitz, argued that there was a trade off between risk and return. He demonstrated, mathematically, that investors are rewarded for the level of risk they take He also showed, that for every level of risk taken, there is a combination of investments that is the best combination available for that level of risk. Most of us who have investment portfolios have a portfolio that combines different asset classes (US Stocks, international stocks, bonds). This type of diversification was all started by Harry Markowitz.

The portfolio model Markowitz invented was based on the statistics of mean (average) return and the variance of the data points around the mean. These models would say something like - if you invest in a 100% stock portfolio you could have a one year return of negative 50% a couple times a century. A good financial advisor should explain that to an investor.

In 2008 the market experienced one of those couple times a century years. Some in the financial press shouted that MPT failed. I have to say, that when I would read or hear this I struggled, because 2008 was not outside what the models FOR PROPERLY DIVERSIFIED PORTFOLIOS predicted. This is not to say that other models that the banks and others were using to make bets on the housing market did not fail, they did. But if you were an average investor who had a portfolio built on an MPT foundation, your return was within the prediction of the model.

Attached is a great interview with Markowitz in last months Journal of Financial Planning:

http://www.fpajournal.org/CurrentIssue/TableofContents/May201010Questions/

Here he explains and defends MPT. He is a modest genius who should be read and listened too.

Bogle on long term investing

In chapter one of Common Sense on Mutual Funds, John Bogle makes the following recommendation on stocks: He states that based on the historical evidence, if your definition of risk is the failure to earn a positive real return (your investments outperform the rate of inflation) over the long term, then stocks are actually less risky than bonds. He says that if you believe that the economy will be healthy over the long term, then the best way to outperform inflation is the stock market.

But, you must be prepared for periods of negative returns. Sometimes over several years.

It is important to note that Bogle defines risk as an investment that does not outperform inflation. Some investors cannot stomach the ups and downs of the stock market and for them, risk is having their investment earning negative returns. Outperforming inflation does not matter to them.

Also note that he is stressing this for the "long term investor." My advise on the definition of long term is 10 years or more. Therefore if you have need for your money in a period of less than 10 years the stock market may not be appropriate.

Finally, Bogle stresses the need to include Bonds in your investment portfolio. Bonds will generally act as insurance to your portfolio during poor stock market periods.

I will discuss portfolio allocations and risk issues in future blogs.