“What goes up must come down. Spinning wheel got to go round…”

Perhaps you recognize this opening line to a popular song from 1969. David Clayton-Thomas was probably not thinking about portfolio theory when he wrote that lyric, but it does apply.

Inefficient diversification can result in unnecessary risk.

To cite but one fairly recent example, many investors can confirm that what went up in the 1990s did, indeed, come down in the early 2000s. It was the fall of the technology titans. The new economy was badly battered and bruised. Some investors suffered greatly in the net worth area.

Many investors suffered losses because they thought being diversified meant owning Cisco Systems AND Worldcom. Some thought they would be able to recognize a bursting bubble in time to safely capture their profits, only to find that bubbles can burst very quickly, and profits can become losses faster than you can say, “Yahoo!”

Want proof? On September 15, 1998 Worldcom and MCI completed the largest merger in history at that time according to the Washington Post. On December 31, 1999 shares of Yahoo! Inc. (YHOO) traded for $108.17. On March 31, 2000 shares of Cisco Systems Inc. (CSCO) traded for $77.31. Less than two years later, as of September 28, 2001 your Yahoo shares would fetch only $4.41 each, and as of September 30, 2001 CSCO traded at a mere $12.18. On July 21, 2002 MCI/WorldCom declared what CNNMoney identified as the largest bankruptcy ever. These are only a few of the many major companies whose stock prices plummeted during the first “bear market” of the 21st century. And another market collapse, much worse in many ways was to follow just a few years later.

Many investors suffer because they are unaware of strategies for reducing risk.

Efficient diversification can reduce risk.

Did you know that you can now use the same strategy that pension managers have employed for decades to reduce investment risk? It’s called efficient diversification, and it was developed by Harry Markowitz, PhD., who won a Nobel Prize for his work.¹ Pension managers, who are responsible for wisely investing billions of retirement dollars, have used this strategy for more than 30 years. We’ve been using this technique for the benefit of our clients since 1989.

The idea, put very simply, is that some asset classes tend to move up when others move down. A good example of this relationship would be the airline industry and the oil/gas industry. When oil/gas prices are stable or moving down, airline profits (and airline stock prices) tend to go up, and when airline profits move down oil/gas profits tend to move up. Of course, economic conditions are constantly changing, and therefore, what went down can eventually go up, and what was up can come down. The matter gets more complicated as new and different situations and factors enter the picture. Some companies never recover, and new ones are born. But the basic axiom of cyclicality remains nonetheless.

Inefficient diversification can screw up your plans.

Do you know anyone who has had to postpone retirement, or whose retirement income was greatly reduced because his or her investment portfolio was not well diversified? Sadly, it has happened to many people. Sometimes people find out too late that reducing portfolio risk is not likely to be accomplished by naively choosing among stocks, or other investments.  Strategy matters.

The goal is to have a steady growth. Real growth. Growth that is greater than the rate of inflation. We believe most investors can and should get a compound return which is two to four times the rate of inflation over periods of five years or longer.² And, by applying Markowitz’ science, we believe this type of growth can be achieved with about half the risk of investing in S&P500 stocks alone.³  

Many investors are not aware that reducing the risk, or volatility of portfolio returns can lead to greater wealth accumulation. A discussion, with proof of this fact is given in our August, 2013 newsletter, beginning on page 3 (quiz) and continuing on pages 5 through 8. The newsletter is in PDF format and can be found here.

We want our clients to sleep well, confident that they are getting a good, reasonable return, without unnecessary volatility, and regardless of which classes, sectors, or industries are currently in favor, or out of favor. For investors with the right strategy, “Spinning Wheel” is just a good song, not cause for alarm.

While pension managers make use of the Markowitz concept, most individual investors do not. As a result, most investors lack the consistency of growth potentially provided by optimization.

¹ Markowitz Mean Variance Portfolio Optimization is an investment strategy which has been the subject of many analytical papers and books.  Originally the subject of Harry Markowitz’ graduate dissertation at the University of Chicago, it has become a central theory in financial economics.  Dr. Markowitz shared in the 1990 Nobel Prize in Economics for this work.
² Results cannot be guaranteed
³ Risk measured by 1-year standard deviation of expected returns; Standard deviation is a measure of the volatility of an investment as defined by the highs and lows of the investment’s price.  Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.  Past performance is not indicative nor a guarantee of future results.  The S&P500 is an unmanaged stock index.  S&P500 is a registered trademark of Standard and Poor’s Corporation.  Investors cannot invest in the S&P500.  Past performance is not indicative of future results.

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