There’s Only One Right Way to Build a Portfolio

Steve Nash is the point guard for the Phoenix Suns of the NBA. Looking at some of his career statistics, in many ways they are pedestrian. Through the end of the 2006–07 season he had averaged 14 points and less than 3 rebounds per game. Certainly there are those with far better statistics who many would consider better players. Kobe Bryant of the Los Angeles Lakers is one example. Yet, Steve Nash is a perennial all star and two-time Most Valuable Player—an award that Bryant has never won.

Nash won such accolades because his contributions go beyond his individual statistics, especially points and rebounds. Nash’s main contribution is that he makes everyone around him better players. This attribute is why Nash is generally considered the greatest point guard of his era. It is also demonstrates why it is important to not view a player’s value to the team by viewing his statistics in isolation. One needs to consider how the player impacts the team’s overall performance.

The same thing applies to investing. A common mistake made by investors and even professional advisors is to view an asset class’s returns and risk in isolation. Just as the only right way to consider the value of Steve Nash is to consider how his play impacts the entire team, the only right way to view an asset is to consider how its addition impacts the risk and return of the portfolio.

In 1990, Harry Markowitz was awarded the Nobel Prize in economics for his contributions to Modern Portfolio Theory. Markowitz demonstrated that one could add risky, but low correlating, assets to a portfolio and increase returns without increasing risk (or, alternatively, reduce risk without reducing returns). The following example will demonstrate just how important it is to consider investments in the whole.

From 1991 through 2007, the S&P 500 Index returned 11.41 percent per annum and had a standard deviation of 17.0 percent per annum. During the same period the S&P GSCI (Goldman Sachs Commodity Index) returned just 6.80 percent and had a standard deviation of 25.6 percent. Why would anyone consider including in a portfolio an asset class that experienced 4.61 percent per annum lower returns than the S&P 500 Index and also experienced much greater volatility? If you considered investments in isolation, that would not happen. However, a portfolio that consisted of 95 percent S&P 500 Index and 5 percent S&P GSCI would have provided a slightly higher return (11.42 versus 11.41) with a lower standard deviation (15.94 versus 17.0). Higher returns with less risk. This outcome was a result of the impact of the negative correlation (-0.20) of returns of the two asset classes. (We can define negative correlation as when one asset produces higher than average returns the other tends to experience lower than average returns.) Every investor should prefer the portfolio that included the lower returning and more volatile S&P GSCI.

As another example, consider the following. From 1970 through 2007, the EAFE (Europe, Australasia and the Far East) Index returned 11.57 percent per annum and had a standard deviation of 21.63 percent. During the same period the S&P 500 Index returned 11.07 percent with a standard deviation of 16.62 percent. Now consider a European investor: Should they have included the lower returning S&P 500 Index as part of their portfolio? A portfolio that was allocated 50 percent to each of the two indices would have returned 11.63 percent, higher than the return of either index. And, by including the lower returning S&P 500 Index the portfolio’s standard deviation also fell from 21.63 to 17.07 percent. Once again we see an example of higher returns with less risk.

From a U.S. investor’s viewpoint the combined S&P 500/EAFE portfolio also produced superior results. The portfolio with both asset classes increased returns from 11.07 percent per annum to 11.63 percent per annum (a relative increase of 5 percent). And while the standard deviation did rise from 16.62 percent per annum to 17.07 percent per annum, that is a relative increase of less than three percent. Thus, the combined portfolio produced superior risk-adjusted returns.

When considered in isolation, commodities appear to be a low returning, risky asset. Yet, their inclusion has historically improved portfolio performance.

Summary

John Ruskin was an author, poet and artist best known for his work as an art and social critic. His essays on art and architecture were influential in the Victorian and Edwardian eras. He stated: “Not only is there but one way of doing things rightly, but there is only one way of seeing them, and that is seeing the whole of them.”[^1] Ruskin’s advice applies to investing. There is only one right way to build a portfolio—by recognizing that the risk and return of any asset class by itself should be irrelevant, and that the only thing that should matter is considering how the addition of an asset class impacts the risk and return of the entire portfolio.

1. Richard M. Titmus, Commitment to Welfare (George Allen and Unwin Ltd., 1976).

_{Disclosure: Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn’t Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).}

_{His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.}

Comments

[dsilisk]

Bull. This is total bull. This reflects everything wrong with investors: the pseudo-mathematical games of MPT, CAPM, and VAR are a detriment to all investments, as well as a JOKE to people who understand the true math behind probability.

Modern Portfolio Theory, the way portfolio risk/return is caluclated, and Value at Risk, the risk management technique of most investment banks, are both flawed because they rely on mathematical models of probabilty distributions which are not appropriate models of the market. The market correction of March, 2007, should have happened once in 8 billion years, according to their model, but it happened again in august and its happenning again in Jan '08.

Reliance on probability distributions is only appropriate if the higher moments of those distributions are calibrated to reflect actual market performance. however, since higher moment calculation is an advanced mathematical technique, the banks aren't technologically advanced enough to use it. therefore probablistic modeling of stock returns will result in statistics that do not correlate to actual events. other models, such as factor models, catastrophe theory, and moving-average risk calculations are safer, albeit more mathematically complex, tools.

Risk is a moving target. Risk metrics should not be fixed, i.e. risk being determined by historical prices. Risk/reward metrics should be calculated within factor models which determine the correct exogenous variables which determine how much value to place on risk. Catastrophe theory, moving-average composition, and factor models MUST be developed in order to make sense of risk/return in a viable (i.e. mathematically sound) sense.

Stop lying to everyone! Stop telling them this whole "risk/reward"... thing works. You finance people call variance volatility, and you call volatility risk. That is like the dog saying "All cats have four legs. I have four legs. Therefore, I am a cat." Flawed logic RULES on Wall St., I guess that is why we are in this whole housing/credit debacle in the first place.

If you want to discuss these ideas further, please do email me at daniel.siliski @ rogue-economics.com. Lets put the real math back in finance.

[User 1123]

"The market correction of March, 2007, should have happened once in 8 billion years, according to their model"

If your math is any good, show us how those models predict such a correction once per 8 billion years. I'm not sure where you go that from, but that is definitely not what those models say. You took that 8 billion number from some quotes by hedgies, who were talking about something different.

[User 1123]

Meant to write "You _probably_ took that 8 billion number..."

[tkenyon]

Volatility does not equal risk. Simple as that. dsilisk has it right, whether or not his 8B year number is right. It's shocking how much money and resources are wasted on so called risk management and portfolio design, which create no real value.

[seen it allbefore]

And according to your reasoning I probably could have married Marlyn Monoe.

[seen it allbefore]

Yes: Marlyn Monoe - you PROBABLY couldn't get the spelling right either.

[JohnB]

How do you get a greater portfolio return than the weighted average return of the asset classes? Are you assuming periodic rebalancing across classes?