Last week we discussed the Free Markets and the Efficient Market Theory. We learned that:
- Stock Picking
- Market timing.
- Track Record Investing.
were signs that you were speculating and gambling with your money.
The equity markets are far too efficient to be able to consistently ‘beat’ the market. Because the equity markets are efficient they are random and unpredictable. We will now explore the next component of a successful investment portfolio. That component is Modern Portfolio Theory.
Modern Portfolio Theory won the Nobel Prize in Economics for Dr. Harry Markowitz. The main component of Modern Portfolio Theory is that diversification works. In fact asset allocation explains more than 90% of a portfolio’s variability.
When we combine asset classes with low correlation we can reduce risk and increase return. Without becoming too technical this means that if you combine low correlated assets in a portfolio, when one is down another has a good chance of being up.
This is best illustrated with the Markowitz Efficient Frontier. Which essentially shows what the expected return is for an expected level of volatility(risk). If you want to earn more return you must assume more risk. So, for example, a young person has a much longer time horizon and therefore would assume more risk to earn a higher return. Conversely, a retired person would assume less risk because their time horizon is much smaller and wishes to take income from their portfolio while keeping up with inflation.
Modern Portfolio Theory has recently been criticized by the Wall Street bullies. During the 2008 crisis all portfolios declined. Critics say that this is proof that Modern Portfolio Theory does not work. They say ‘look all of your low correlated assets are down and Modern Portfolio Theory did not protect you’. Modern Portfolio Theory was never intended to eliminate risk but rather to control risk. The 2008 crisis was an exceptional time nearly unprecedented. I believe that if you build a portfolio to protect against what happened in 2008 you will be disappointed in your return, long term.
As I have mentioned in the past and it bears repeating, from 1926 thru 2012 the S&P 500 earned 9.73% per year. During this time there were 22,040 trading days. Of these trading days 48% were down or approximately 10,579 days down and 11,461 days up. Many of you realize that this is one of my favorite statistics so be prepared to read this again.
Please keep in mind that the Wall Street bullies use financial pornography to sell product. These bullies use fear AND greed to keep investors trading.
If you have a process you believe in and stick with it you will succeed long term. There is no one perfect answer. You will experience down markets and some will be very emotional. You will experience up markets and some will be very emotional. Right now we are experiencing one of those emotional moments with the government shutdown and potential default.
With the guidance of an investor coach you can realize a successful outcome to your financial strategy. On your own in most if not all cases you will allow your emotions to decide how to invest. This can be very destructive to your financial future.
Your investor coach will protect the future you from the current you.
So far we have discussed two of the technical components of a successful portfolio. Next time we will discuss the final component The Three Factor Model. Stay tuned.