Markowitz’s Modern Portfolio Theory: What Investors Get Wrong

In its simplest interpretation, Harry Markowitz’s modern portfolio theory demonstrates that greater risk is positively correlated with return and thus greater risk provides investors with a greater return.

As laid out by Markowitz, investors have been rewarded by the risks they’ve taken broadly across asset classes. However, there are caveats that go along with Markowitz’s theory – that all investors agree on the underlying risk and return of each asset and that there are neither trading costs nor taxes.

Taking this one step further, within asset classes, especially equities, investors have extrapolated Markowtiz’s financial theory in making the assumption that higher-risk equities should outperform lower-risk equities. Yet numerous research papers, including research by S&P Dow Jones Indices, show that this just isn’t true. In fact, higher-risk equities tend to produce lower investment returns versus lower-risk equities over full market cycles.

Identifying Risk Factors

Risk characteristics are never static; these characteristics are dynamic traits, evolving with time as the markets fluctuate, react and change. Many businesses’ financial reports show seasonality, sprinkled with times of faster growth and periods of contractions. Sectors, industries and the individual companies within all exhibit varying trends of successes and failures. With a low-volatility approach that identifies stocks that are less apt to fall and rise rapidly, an experienced investment manager will look to mitigate some of these risk factors within a portfolio.

In order to maximize one’s return at constrained risk levels, it is important to first identify which risk characteristics may have the greatest affect on your portfolio. Fully understanding a company’s future prospects, their place within the current market structure and their past stock behavior assists in better understanding which factors to weight higher or lower during the construction process.

Avoid individual company and sector concentration risks. Research by Vanguard shows that building a broadly diversified portfolio across industries lowers one’s risk. Individual companies tend to announce failures without warning, exposing their investors to significant losses. This risk is minimized by investing in a diversified number of holdings. Distinguishing potential detriments among individual stocks is key to gaining a bigger picture of the risks you are carrying.

The key here is knowing the potential negative factors in your portfolio.  Such knowledge can help you better construct a more ideal portfolio, one with lower downside risks.

Building a Smarter Portfolio

Accepting the idea that more risk does not equal a greater reward goes against most individuals’ theoretical belief systems, as cognitive dissonance plays a huge role in how we actually invest. The first step is to identify the most statistically attractive companies utilizing quantitative methods based on a diversified set of factors. In addition to understanding quantitative factors, performing a detailed fundamental risk analysis to supplement your quantitative screening is necessary. This detailed risk analysis helps you gain a clearer picture of the overall individual names, industries and sectors that are qualifying for your portfolio.

Understand where your risk changes in your equity holdings. Try to position your portfolio on the “steepness of the curve.” Recognize where the market’s optimal risk-to-reward ratio lies. Increasing your risk past this point generally lessens your risk-to-reward ratio.  Greatly increasing risk beyond the optimal ratio generally will begin to detract from potential gains. Try to ignore your cognitive rule of greater risk equals greater return and remember instead that greater risk only equals greater risk.

Monitor current portfolio holdings to keep an eye out for potential downsides; this way you will be ready to act accordingly should the market take a sudden dip. Some important stock attributes your holdings should exhibit are lower volatility, higher quality characteristics, perhaps trading at a discount to fair value or a history of increasing dividends. Over time, this lower-risk strategy may result in a higher return per unit of risk and a more prudent portfolio.

Why It Works

Low-volatility equity strategies should, by design, attempt to lower the risks investors take with their equity holdings. Whether measured by beta or standard deviation, low-volatility equity strategies seek to provide a greater return over a full market cycle compared with their cap-weighted benchmarks all while maintaining a lower risk compared to your benchmark. Though the performance of lower-risk, low-volatility strategies vary, managed-risk strategies should help investors feel more comfortable in their equity investments, even if they experience a dip in the market.

This low-volatility effect is being actively researched and tested by more institutions as investors look for ways to de-risk their equity exposure. Factor investing, smart beta and liquid alternatives are some of the terms being applied to strategies that are less concerned about tracking error relative to a cap-weighted index. You do not need to take benchmark risks or greater in order to position your portfolio to earn benchmark or higher returns. The comfort and satisfaction of knowing your investments are prudently invested and de-risked over a medium to long-term investment horizon may allow more investors to stay the course.

Providing clients with sound risk management, educating them about stock market returns and lowering the volatility within equity portfolios may provide investors less volatile return streams, meaningful upside capture and more capital protection during negative markets.

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