By: Frank Armstrong, CFP, AIF

A young widow with two children, who is struggling to get by, will certainly need a different portfolio than her single friend on the corporate fast track. But how should their investments differ? And how can they each best achieve their needs for safety, income, and capital appreciation?

**The Old-School Way**

The old-school approach was to design an individual portfolio from scratch for each investor. This method of individual portfolio design has been called the interior-decorator approach to financial consulting. Investors were thought to require hand-tailored solutions constructed on a stock-by-stock basis. The widow, whose goal is safety of principal, might have been advised to invest in bonds, convertible stocks, utilities, REITs, and high-yielding blue-chip stocks. The corporate fast-tracker, meanwhile, might have been advised to purchase dot-com startups, small-cap stocks, and technology names to meet her growth goals.

This approach left both the widow and the fast burner with inefficient portfolios, though. Although the fast burner achieved her growth goal, she took on more risk than she needed to bear. Oddly enough, the widow did the same. By narrowly investing in assets with high correlation to one another (in other words, by favoring investments that behaved alike), both failed to maximize their return per unit of risk.

Harry Markowitz’s Portfolio Selection, which I covered last month, wasn’t much help. His work assumed an investor with no need for liquidity, an infinite time horizon, and a proclivity for being either 100% in or out of the market. Markowitz’s investor was concerned solely with maximizing her return at a particular level of risk while choosing exclusively from a universe of relatively risky investments. This investor didn’t live in the real world with the rest of us.

**Tobin’s Way**

James Tobin, who considered himself an ivory-tower economist, solved this real-world problem with an elegant and powerful insight. He simply noted that investors have a full range of liquidity preferences and therefore need to broaden their investment choices to include lower-risk assets. (Tobin was awarded the Nobel Prize for Economics in 1981 for his analysis of financial markets and their relations to expenditure decisions, employment, production, and prices.)

Tobin said investors should first determine their appetite for risk. With that level of risk tolerance in mind, investors can choose the equity portfolio from a Markowitz optimization. In other words, they’d choose the portfolio on the efficient frontier–or the line on a risk-return graph that includes all portfolios with the greatest expected return for a given level of risk–that has the highest return per unit of risk. Investors should then satisfy their liquidity and safety needs with another portfolio, called the zero-risk portfolio. In essence, investors have two buckets–an equity bucket for growth and a liquidity or safety bucket of lower-risk investments, such as cash or short-term bonds–and simply divide their assets between them. In this scenario, every investor, whether widow or corporate fast-tracker, owns the same equity portfolio; the investors temper liquidity needs and risk-reward profiles by adjusting their level of zero-risk assets.

In Tobin’s own words, “You would choose the same portfolio of nonsafe assets regardless of how risk-averse you were. Even if you wanted to change the amount of risk in the portfolio, you’d do it by changing the amount of the safe assets relative to the nonsafe assets, but not by changing the different proportions in which you held the nonsafe assets relative to each other.”

But what if a 100% equity portfolio fails to satisfy an aggressive investor’s need for risk-return potential? The investor could either leverage the portfolio or buy it on margin.

**A Few Problems**

Tobin’s great advance left two problems unsolved. The first was the question of what exactly the dominant equity portfolio should be. The race to determine the superefficient portfolio was on. And then there was the problem of simplifying the math: Modern portfolio theory was so math-intensive at this stage that it didn’t offer much practical help to everyday investors. Markowitz had suggested an approach to the math as a footnote in his paper, but he left the problem for a student (Bill Sharpe) to solve. Simplifying the math eventually led to the solution for the superefficient portfolio. But that’s another story for another time.

**To Learn More**

The February 1958 issue of The Review of Economic Studies featured Tobin’s “Liquidity Preferences as Behavior toward Risk.” Tobin describes in layman’s terms how he came to the separation theorem in an interview with the Federal Reserve, ; he also relates how he came to be a character in Herman Wouk’s The Caine Mutiny. Peter Bernstein tackles Tobin’s concept in chapter three of Capital Ideas, perhaps my favorite book on modern finance.

**Next Time**

Does a company’s dividend indicate anything about the value of the stock? Is there an optimum ratio of stocks, bonds, and bank loans for a company? Should investors prefer companies with high leverage or strong balance sheets? Merton Miller and Franco Modigliani proved that everything I learned about this in college was dead wrong. On Thursday, March 23, I’ll share what I learned.