Portfolio Magic
Here's a great idea: let's add something risky to your investment portfolio.
One of the mathematical mysteries of investing--which earned Harry Markowitz a Nobel prize in economics--is how it's possible to add volatile investments to an investment portfolio and get higher returns with less risk. Roger Gibson, author of "Asset Allocation and the Rewards of Multiple-Asset-Class Investing," recently showed an audience of financial advisors some updated statistics on how this works.
Let's suppose that in 1972, you were to visit a gypsy and ask her to look into her crystal ball. You ask her to tell you what the returns will be on U.S. stocks (measured by the S&P 500 index), international stocks (the MSCI EAFE index), real estate securities (the FTSE NAREIT Equity REIT index) and commodities (the S&P GSCI Index) ending in the year 2009--December 31 of last year.
The gypsy tells you with perfect accuracy that U.S. stocks will rise 9.91% a year, international stocks will go up 10.28% a year, real estate securities will go up 11.62% annually, and the yearly return on commodities will be 9.56% a year. What would you do with this information?The intuitive answer is to put it all in the asset that will go up the most--the real estate market. But the modern portfolio theory answer is that you would do better if you invested equal amounts of money in all four assets. Your overall return would be a hair below the REIT return--11.58% a year--but with dramatically lower volatility. In many time periods, combining all four asset classes will actually result in a higher annual return than the highest individual asset class return. In other words, even if you could find a gypsy who had perfect foresight, you would still be better off combining different assets together.
Mr. Gibson shows the return since 1972 of each individual asset class, and how adding another risky asset will actually reduce the overall up/down movements of the blended portfolio. Add another risky asset, and the overall return tends to go up and the volatility goes down. Add another, and you get more of the same effect.The magic is in what Markowitz called the correlations; that is, the amount that one asset moves in relation to the others. If the correlations are equal to 1, all the assets go up and down in tandem. If they're less than one, then you tend to get this multiplier effect on return and dampening effect on risk--and the lower the correlations, the better this works.
This, of course, is only one component of portfolio design; you also want to have diversification within each asset class, and control costs, and a variety of other elements. But getting the overall asset mix right is the most complicated part of the formula--and, seemingly, the most magical and mysterious. If you can achieve results that are better than a person with perfect foresight, isn't that pretty remarkable?
