By: Frank Armstrong, CFP

In our last installment, we made significant improvements to the bond portion of our portfolio. Now let’s turn our attention to the stock portion. I’ve listed the risk-reward positions of various markets around the world. These are the basic building blocks for asset allocators. You will notice that some of the risk numbers are pretty high. Our trick will be to capture some of the performance without increasing risk.

First, let’s look at how Modern Portfolio Theory works, and how it can help us build portfolios with both higher returns and lower risk. The defining text of modern finance, in my opinion, is Harry Markowitz’s doctoral dissertation, later published as Portfolio Selection. Believe it or not, before Markowitz wrote this paper in 1952, nobody had ever defined risk in the investment process, or discussed how it might be contained and controlled. The paper became the basis for Modern Portfolio Theory, and forever transformed investment practices. In 1990 Markowitz shared the Nobel Prize in Economics for his pioneering work. Like all great ideas, it’s so simple that that we all wonder why we didn’t think of it first.

Markowitz observed that assets have both a rate of return and a risk. He defined risk as the variation in returns, and measured it with standard deviation. Then he noted that asset returns don’t necessarily move in lock step. Those that move together have high correlation, those that move in opposite directions have negative correlation, and those that don’t seem to have any related movements at all have zero correlation.

Imagine that we have an asset that produces high returns while generating high risk. If somewhere in the world we could find an asset that always went up when the first went down, and vice versa, we would say that the two assets had perfect negative correlation. If we mixed these two assets together to form a portfolio, and measured risk at the portfolio level instead of the individual asset level, the resulting mix would display high return and no risk!

Smooth sailing: In this hypothetical example, two high-return, high-risk assets with perfectly negative correlation combine to produce 15% annual returns–with zero volatility.

Sadly, there are no two assets with perfect negative correlation. But the good news is that anything less than perfect positive correlation will help reduce risk in our portfolio. So, the key to portfolio construction is to mix together assets with satisfactory risk-return characteristics and low correlations with our other assets.

Even with just two assets, however, we can devise an infinite number of portfolios. Luckily for us, only one of those portfolios will give us the maximum rate of return at each risk level. If we connect all the points that have the maximum rate of return at each level of risk, we form a line that Markowitz called the Efficient Frontier. Each of these points falls above the old risk-reward line, and the additional return available without additional risk is as close to a free lunch as investing will ever provide.

Here is a familiar example of how Modern Portfolio Theory works in practice. Imagine a world in which investors can invest in only two asset classes: Large U.S. stocks represented by the S&P 500 index, or large foreign stocks of developed countries represented by Morgan Stanley Capital International’s Europe, Asia, Far East index (MSCI EAFE). Notice that EAFE has both a higher risk and rate of return than the S&P 500.

We would expect that if we mixed the two together in a portfolio, the resulting risk and return would fall on the line that connects them. However, because the two have low correlation to one another, a funny thing happens on the way to the bank. If we start with an all U.S. portfolio (S&P 500) and gradually add foreign stocks (EAFE), our portfolio’s rate of return rises, but its risk actually falls! Somewhere between a 20 and 30% EAFE weighting, the portfolio’s risk reaches its lowest point. As we add more foreign stocks, rate of return increases, but risk does too. Somewhere between 30 and 40% EAFE turns out to be the optimal mix if we only have these two asset classes to consider. In the real world, we have multiple asset classes, so the optimal percentage of foreign to domestic may shift considerably.

Americans have such wonderful investment opportunities domestically that many are not used to thinking about international exposure, but there are powerful reasons why they should.

Today, America is one of the most productive and profitable economies in the world. Our stock markets have enjoyed an almost unprecedented bull run for several years. But it wasn’t always so. A few years ago many Americans believed that we were destined to be just a small, backward, and unimportant outpost of the Japanese. American managers were told to ape their consensus style of management.

But, the worm turned, as it always does. Japan Inc.’s centrally directed economy has developed critical weaknesses lately, while we are enjoying the fruits of years of hard restructuring. Today, however, anyone who thinks the American economy is invincible and that our markets can continue to go straight up forever is suffering from serious delusions. An investment strategy based on that flawed premise is not likely to be optimal.

Unless you believe that Modern Portfolio Theory is nonsense, that diversification doesn’t matter, that there are no attractive investment opportunities beyond our borders, that American markets will never falter, and that foreign markets will never recover, you will want to diversify internationally. For now, let’s split our model portfolio’s stake in stocks equally between the S&P 500 and EAFE.

Because the recent market performance in the U.S. has been so unusually strong compared to foreign markets, this first step into equity diversification produces only a modest improvement in our portfolio. However, it sets the stage for dramatic improvements as we add other asset classes later.