Unconventional wisdom: The only free lunch in investng?
Harry Markowitz argued investors could get something for nothing, but the reality is more complex.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: The only free lunch in investing?
Theres no such thing as a free lunch
- Milton Friedman
Harry Markowitz spent his life trying to prove investors could get a free lunch. He invented Modern Portfolio Theory in 1952. Thirty-eight years later he won a Nobel Prize. Regardless of what you think about his work Markowitz’s career showed that patience isn’t just important in investing.
At the core of Modern Portfolio Theory is diversification. Markowitz is the one that called diversification the only ‘free lunch’ in investing.
I hear a lot of investors use that quote. But I suspect many of them haven’t thought too much about what Markowitz was saying and if his theory has any application to their own portfolio.
The origins of the ‘free lunch’
The idea for Modern Portfolio Theory came to Markowitz at the library when he was reading John Burr Williams’s ‘Theory of Investment Value.’
I like John Burr Williams. He wrote a poem about dividends and took a very pragmatic approach to investing for an academic theorist. I wrote about him here and included his ode to dividends for all the poetry lovers.
In reading Willams’s theory on the value of individual securities it occurred to Markowitz that focusing on an investment in isolation ignored how a group of investments interacted as part of a portfolio.
Markowitz wanted to account for the trade-offs required with investing. In theory every investor wants the highest return and therefore would put 100% of their money in their best idea. But in practice this approach is extremely risky and investors should strive to build a portfolio that accounts for both risk and return.
Markowitz added a third factor to consider in portfolio construction. It isn’t just the risk and return characteristics of each investment in a portfolio but also how the prices of different holdings move in relation to each other – in other words their correlation.
Modern Portfolio Theory provides the mechanism to use those three inputs – expected return, risk as measured by standard deviation, and correlation – to calculate an optimal portfolio weighting for each asset.
This is done through mean variance optimisation which is the framework Markowitz used to create the perfect portfolio at each given level of risk.
This is what turns a group of assets that an investor thinks are individually great opportunities into an optimal portfolio precisely weighted to deliver the highest return at a given level of risk.
This is the ‘free lunch’. By diversifying properly and getting the mix of each asset right an investor gets a portfolio that is more efficient from a risk / return perspective than any of the assets in isolation.
The ‘free lunch’ is a diversified portfolio where the sum is worth more than the parts.
Does the ‘free lunch’ exist in the real world?
When I was younger, I loved theories like this. The mathematical precision appealed to me and I genuinely thought there was a formula that could be used to get better investment returns. I’ve since developed a more nuanced view of academic investing theories.
The problem is not Markowitz’s mean variance optimisation framework. I’m sure it is mathematically brilliant. The problem is the old adage: garbage in, garbage out.
If you want to apply this theory to your own portfolio you need to know the expected return, volatility and correlation of different portfolio holdings. This is the problem.
Historic figures for measures like volatility and correlation show little consistency which makes them poor predictors of future outcomes.
Below is a chart from Graham Capital Management showing the correlation between the S&P 500 and 10-year US Treasuries over the last century.
The inconsistency of historic data shows the challenge for any investor wishing to forecast the correlation between different assets. The other problem is correlations tend to change during times of crisis. Asset prices that normally move interpedently can start to plunge in lockstep.
The correlation between different assets isn’t the only challenge with implementing Modern Portfolio Theory. It is also extremely difficult to forecast the expected return and volatility of different assets.
It is very difficult to effectively apply Modern Portfolio Theory in real life. It is likely that only a sophisticated professional investor could even make an attempt. That doesn’t mean it is useless.
The question is how an everyday investor can apply the theory to make better investment decisions. I have some suggestions.
Be clear about what you are trying to achieve and if Modern Portfolio Theory aligns with your goals
Modern Portfolio Theory focuses on the relationship between volatility and returns. If your goal doesn’t align with that view of the world the theory is less helpful. It doesn’t account for other common goals like income, liquidity or retirement.
For instance, at this stage in my life volatility is not something I consider a risk. I have a long timeline to invest and I’m not selling off my portfolio to pay for my life so I’m not subject to sequencing risk. I can psychologically and financially withstand a bear market without having to sell.
What I am interested in is the average annual return I can achieve over the next twenty years. At this stage I’m not worried about the variability of those returns.
This means the correlation of different assets in my portfolio isn’t my primary concern. Holding uncorrelated assets is great for an investor that wants to lower volatility - if asset A goes down at least asset B goes up.
I’m more interested in John Burr William’s view of the world and finding individual assets that I believe will have high expected returns over the long-term. I can judge those assets on their individual merits without worrying about how their returns interact.
I don’t diversify to create an optimal portfolio. I diversify to reduce the risk of not achieving my goal because one of my positions suffers a permanent loss of capital. I am trying to diversify away single security risk and not volatility.
In a practical sense that means I can ignore any argument for a particular investment that is based on a lack of correlation with another investment. This provides a helpful lens when I evaluate potential investments.
The argument that an investment is uncorrelated with more vanilla investments like stocks or bonds is often used to try and justify the inclusion of a new type of investment in a portfolio. Many of these new types of investments have higher fees.
An example is the inclusion of private assets in individual investor portfolios. For some investors private assets may play a productive role in a portfolio. For others they won’t.
Understanding Modern Portfolio Theory is helpful as you can decide if it applies to your personal circumstances. That way you can align your goals with the justifications for certain investments.
Take a holistic view of your portfolio and diversify with purpose
Even if your goals don’t align with Modern Portfolio Theory there are some good lessons when you are trying to put together a portfolio.
Aligning your portfolio to your goals is more useful than simply looking at each individual holding. Having a diversified portfolio mean accepting that not everything you own is going to perform great all the time.
Strategies and individual companies are going to fall into and out of favour. Instead of worrying about each holding make sure your portfolio is aligned to what you are trying to achieve.
For instance your asset allocation should reflect the return you are trying to achieve and any secondary goal like lower volatility, liquidity or income generation you may have.
Markowitz’s key observation remains valuable. Each asset has a role to play within a portfolio.
Diversification does not mean you should own every type of investment. Understand the role of each investment and how it fits into your overall portfolio – don’t mindlessly keep adding new types of investments to your portfolio.
Final thoughts
Warren Buffett famously said the biggest risk with investing is not knowing what you are doing. This does not mean you need to know everything.
Understanding academic investment theories is not a prerequisite for successful outcomes. Issues arise when you attempt to apply a theory without considering if it is aligned with what you are trying to accomplish.
If you are inclined, spend your time learning about different investing concepts and theories. If you are like me, you will find this effort worthwhile and interesting.
Markowitz’s work is one example of how to build a portfolio. There are several others approaches you could consider for your own portfolio. To figure out your personal plan start with understanding your own situation and what you are trying to accomplish.
With all thy knowing, know thyself.
Quesitons, comments or restaurant recommendations? I can be reached at [email protected]
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What I’ve been eating
Some lunches are worth paying for. I’ve been going to Husk in Nashville for almost twenty years and their current version of shrimp and grits is one of my favourite all-time dishes. Shrimp and grits is American history – good and bad – on a plate. Native Americans taught early settlers how to grind corn into grits. Enslaved cooks leaning on West African traditions of combining maize and shellfish added shrimp to the grits. The dish migrated out of low-country South Carolina and onto restaurant menus across the country.
Husk’s version uses a green gumbo as the gravy. Green gumbo combines numerous greens like collards, kale and mustard greens. Traditionally it was thought that each green you add to your gumbo brings another friend into your life. Jalapeno and Jimmy Nardello peppers are added along with sesame seeds. This is a lunch worth paying for.
