If the first rule of portfolio management is diversification,
why do most investors unwittingly concentrate their risks?
Many investors believe that a portfolio constructed with
numerous stocks and bonds is diversified. That approach has
its roots in the principles of Modern Portfolio Theory (MPT).
Yet when MPT is misapplied, it does not provide the roadmap
to secure investing and leaves investors vulnerable to substantial
MPT was developed in the early 1950s by Nobel Prize
winner Harry Markowitz. His principles were simple to understand
and striking by their implications: diversification can eliminate
the risks that dont provide returns, while retaining
the risks that do provide returns. Dr. Markowitz and his colleagues
Merton Miller and William F. Sharpe further developed these
principles into the Capital Asset Pricing Model (CAPM).
From Jonathan Burtons interview with Dr. Sharpe, he
reports: Every investment carries two distinct risks,
the CAPM explains. One is the risk of being in the market,
which Sharpe called systematic risk. This risk, later dubbed
"beta," cannot be diversified away. The other
unsystematic riskis specific to a company's fortunes.
Since this uncertainty can be mitigated through appropriate
diversification, Sharpe figured that a portfolio's expected
return hinges solely on its betaits relationship to
the overall market. The CAPM helps measure portfolio risk
and the return an investor can expect for taking that risk.
In combination, MPT and CAPM have been the basis for structuring
investment portfolios for the past several decades. Based
upon an investors risk profile, allocations are made
across the investment alternatives. Decades ago, there were
stocks and bonds, and occasionally an alternative. As a result,
portfolios were developed from a very limited palette. Yet,
the groundbreaking MPT and CAPM principles helped investors
and advisors to structure diversified portfolios of stocks
and bonds rather than concentrated portfolios.
As simple as that sounds, since today those concepts are
second nature in
investing, the Nobel Prize winning team determined that market
risk is the only risk that investors are paid to include in
their portfolios. Since the risks
associated with individual companies can be diversified away,
the systematic market risk is the source of returns. Most
investors have heard this principle said another way: that
80% to 90% of the returns come from being in the market and
a fraction comes from stock selection. Actually, if
an investor is diversified sufficiently to achieve academic
theory, then CAPM indicates that the percentage should be
the entire 100%. Proper diversification should provide investors
with investment returns that are consistent with the market
Lets relate these principles first to stocks and then
to bonds. A diversified portfolio of stocks tends to provide
the returns of the general stock market. Once individual company
risk is diversified, the pure stock market risk remains. Thus,
the portfolio moves with the stock market. Stock market returns
are driven by earnings growth and valuation changes (as measured
by the price/earnings ratio, known as P/E). If P/Es
increase, stock market returns are generally high since the
P/E ratio multiplies the effect of rising earnings. If P/E
ratios decrease, stock market returns will be
low or negative since declining P/Es generally offset
the benefit of rising earnings.
Similar principles apply to bonds. Once the individual company
risks are diversified, the portfolio moves in concert with
the bond market. The bond market is largely driven by trends
in interest rates. As many investors have experienced, when
interest rates decline, bond values increase. Likewise, rising
interest rates cause bond values to decline. Thus, if interest
rates are falling, the yield from the bond portfolio is supplemented
in the value of the bonds; or, if rates are rising, the decline
in bond prices offsets some of the portfolio yield resulting
in lower total returns.
Therefore, an investment portfolio that is structured with
allocations of 60% in a diversified stock portfolio, 30% in
a diversified bond portfolio, and 10% in other investments
is concentrated 90% across two risks: stock market risk and
bond market risk. And over longer periods of time, those two
markets tend to move in the same direction.
This does not indicate that the principles of MPT and CPM
are not solid; the issue is that the application of the principles
has not evolved as the financial markets have become more
complex and sophisticated. Dr. Markowitzs publication
of MPT in 1952 discussed the concept of performances
of available securities. In 1952, there wasnt
much more than stocks and bonds. A portfolio allocated across
the two asset classes was about as diversified as you could
Many investors today may not realize that mutual funds were
uncommon before the 1980s (there were less than 300
in the 1960s and there are more than 10,000 today).
In addition, the investment choices and available
securities have exploded over the past two decades. The menu
of securities now readily includes asset-backed, foreign,
real estate, options, commodities, investment trusts, hedge
funds, inflation-protected bonds, etc.
As well, most investors only remember the market risks and
conditions of the past two decades, when the annual trends
were strongly in favor of stock and bond investors. Interim
dips were always buying opportunities.
However, for those with battle scars from the 1970s
and before, stock and bond market risks have not always been
so forgiving. The driver of stocks, the P/E ratio, is again
at historical highs. The driver of bonds, interest rates,
is at historical lows. Given where both of the traditional
asset classes are positioned, the odds appear to favor Mr.
Risk over Mr. Return
for stocks and bonds.
Over the past several decades, the financial community has
also realized that the theories of market efficiency, an important
assumption for MPT and CAPM, may not be as strict as originally
hypothesized. Financial markets are an efficiency process,
rather than an efficient condition. In other words, markets
function to find the right prices over time, but dont
always reflect all of the information all of the time. Many
of the alternative investments today, hedge funds as an example,
operate to identify and profit from mispricings and inefficiencies
and contribute to the efficiency of the markets.
Returning to Dr. Markowitz, diversification in a portfolio
applies to risks, not securities. Other than not being familiar
with the investment alternatives, what other rational reason
would explain why investors concentrate their
portfolios into two major risks when so many options are available?
Ed Easterling is President of Crestmont Holdings, L.L.C.,
a Dallas-based investment firm that manages a family of fund
of hedge fund portfolios. As well, he is a member of the adjunct
faculty at SMUs Cox School of Business and teaches the
course on hedge fund investment management for MBA students.
Crestmont develops financial market research through its affiliate
Crestmont Research (www.CrestmontResearch.com).