For stock market investors, 1952 was a watershed year. University of Chicago economic student Harry Markowitz published his doctoral thesis, which would make up the foundation for his breakthrough treatise on investing — modern portfolio theory.
The paper’s diversification thesis holds the key to a larger retirement savings portfolio — and to retirement savers, it still matters 65 years later.
In explaining modern portfolio theory, Markowitz’ position is simple, yet direct — eliminating risk is the Holy Grail for long-term investors. (In defining modern portfolio theory, Markowitz cites risk as a standard deviation of expected returns, and that it’s best measured across an entire investment portfolio, and not on a case-by-case basis in evaluating single stocks or funds.)
Here’s how investment experts view Markowitz’s theory, and how it ties into retirement investing.
[See: The 9 Best Investors of All Time.]
“Modern portfolio theory suggests that a well-diversified portfolio of investments will help an investor to maximize the net rate of return while minimizing the risk of large losses,” says Barry Kozak, a consultant with Chicago-based October Three Consulting, and a graduate of The University of Chicago.
Under Markowitz’s theory, there is no perfect mixture of investment choices, Kozak says. “Instead, you have a spectrum of different hedging strategies that, at any given time, optimizes the independence between different modes of capital assets, so that as one of the underlying markets ebbs or flows, due to normal cycles or a shock,” he says. “In that case, the the gains on one portion of the portfolio is always enough to equalize, or at least mitigate, the losses incurred by another portion of the portfolio.”
Additionally, the hedging strategy can change over time for the same investor, and can be tailored to hedge the actual assets any particular investor favors, Kozak says.
Stripped of the Nobel-winning mathematical formula, Markowitz envisioned what now seems to be pure common sense, Kozak says. “The key is minimizing the risk of large losses without applying an irrational fear of any losses, which could then result in an overly-conservative portfolio that never really yields even reasonable rates of return in any given market period,” he notes.
To retirement savers, modern portfolio theory largely defines two key savings issues — risk and liquidity, says Gwen Cheni, a portfolio manager at a hedge fund in San Francisco.
“Because every security has risk, diversification at retirement becomes even more important than during the saving phase,” Cheni says. “Furthermore, it’s imperative that retirees have sufficient funds for the next two to five years of living expenses, plus health care funds, in short-term investment grade bonds or U.S. Treasurys. These securities should not be sold at distressed prices in order to pay for immediate living expenses.”
[See: U.S. News & World Report’s 10 Top-Ranked ETFs.]
Asset allocation is a recurring theme.
“According to Markowitz, asset allocation, not individual assets or securities, is responsible for 90 percent of a portfolio’s return,” and that’s a big theme for any serious retirement saver’s investment portfolio, says Vic Patel, founder of New Jersey-based Forex Training Group.
“Retirees who seek to reduce their risk by reducing their exposure to equities are actually increasing their portfolio risk by introducing more interest rate risk and inflation risk,” he says. “Investing their money in safe or guaranteed instruments may provide peace of mind that they won’t lose any money due to market fluctuations; however, each day that their returns fail to exceed the rate of inflation, they are, in effect, losing money, and that loss becomes more pronounced over time.”
Patel says there are good ways to invest conservatively that will minimize market risk, reduce portfolio value volatility and overcome the risk of inflation. “The key is in knowing what your financial objective is in real terms, factoring in the true cost of living and taxation, in order to know the minimum rate of return you need to generate, and, therefore, the level of risk you need to incur,” he says.
“With an investment strategy tailored to your specific needs, you need not take any more risk than is absolutely necessary to achieve your objective,” he adds.
For retirement savers using target-date funds like the Vanguard Target Retirement 2040 fund (ticker: VFORX), Markowitz “matters a ton” as investors benefit from money managers embracing Markowitz’s theory, says Peter Fisher, a money manager at Human Investing in Lake Oswego, Oregon.
[See: 12 of the Best Target-Date Retirement Mutual Funds.]
“The exactness of his theory is played out best when managers of funds for retirement deploy assets across a broad universe of investments that zig while others zag, creating a wonderful ride in and through retirement while minimizing risk,” Fisher says. “In that regard, it really is the investment Holy Grail.”
As Markowitz says, through proper diversification, an optimal portfolio can be constructed to maximize return for any level of risk tolerance.
In that regard, retirement savers would do well to study up on Markowitz and modern portfolio theory. Doing so could translate into a game changer for your retirement savings program, with a rigorous plan to reduce risk, and keep building assets for your golden years.
More from U.S. News
The Best ETFs Retirees Can Buy
The New Sector Funds: 10 Thematic ETFs
8 Things Not to Hide From Your Investment Professional
Harry Markowitz Should Be a Household Name for Every Retirement Saver originally appeared on usnews.com
