Harry Markowitz developed Modern Portfolio Theory, which theorized that investors could design a portfolio to maximize returns by accepting a quantifiable amount of risk. In other words, investors could reduce risk by diversifying their assets and asset allocation of their investments using a quantitative method, which is known as the efficient frontier; illustrated below.
Harry’s pioneering work was recognised in 1990 when he was awarded a Nobel prize for his research, which remains a key principle of investing today.
When constructing a portfolio, the investors objective will determine where on the efficient frontier the portfolio should sit to optimise risk / return most efficiently.
Sounds simple, establish the objective, and get a computer to model the perfect portfolio, right? No, this would only work if you were dealing with a rational and unemotional investor, which I would argue does not exist. The efficient frontier is pure math and cannot quantify human behaviour or take into account an investors personal tolerance for risk.
Harry was the perfect example of this when he admitted that his personal investments were not allocated according to the principles of the efficient frontier. The man who spent a lifetime developing the perfect scientific investment tool failed to use the methodology in managing his own affairs, instead opting for a simple and more conservative 50 / 50 allocation between cash and equities.
Investors should seek to understand and accept that as emotional being’s we are incapable of taking rational decisions when it comes to managing our own investments. The best we can hope for is a reasonable decision-making effort, which is why I recommend investors partner with a trusted adviser who has the advantage of not being emotionally attached to your money and therefore more likely to make rational decisions. Of-course this assumes you have never physically threatened your adviser. 😉
Mcomm, CFP®, HdipTax
T. 021-205 1133