Our investment approach at North Lakes Financial Group is based on our belief in the Modern Portfolio Theory (MPT) and the power of diversification.
The key takeaways of the modern portfolio theory are as follows:
- It’s a method that can used be to construct diversified portfolios that improve expected returns without taking on additional levels of risk. In other words, it's used to create efficient portfolios.
- It argues that any given investment’s risk and return characteristics should not be viewed alone but should be evaluated by how it affects the entire portfolio’s risk and return.
- It assumes that investors are risk-averse, meaning investors prefer a less risky portfolio to a riskier one for a given level or return. The portfolio’s risk is a function of the variances of each specific asset/investment and the correlations of each pair of assets.
A key component of MPT is diversification. We believe diversification is a necessity in portfolio construction to improve returns while not increasing portfolio risk. I often refer to the graphic below when discussing the power of diversification. Copy and paste the link below into your browser to see what I’m referring to:
quilt_chart.pdf(columbiathreadneedleus.com)
This diagram illustrates historical performance of different asset classes (different types of investments) from 2014 to 2023.
The specific year is listed at the top of each column ranging from 2014 on the far left to 2023 on the far right. Performance is illustrated based on each row. The best performing asset class is listed on the top row all the way down to the worst performing asset class listed on the bottom row.
Here are the takeaways from this illustration:
1) S pecific asset class returns can fluctuate unpredictably over a year-to-year basis:
- Take emerging markets for example. In 2014 and 2015, it was one of the two worst performing asset classes in each year. Then, it was the best performing asset class in 2017 followed by the worst in 2018 again.
- Now, look at the large growth asset class. It has had the best average annualized return over the course of 2014-2023, which can be attributed to a handful of stocks. From 2019 through 2021, it performed the best. Then in 2022, it was the worst performing asset class. In 2023, it performed the best again.
2) Investors often follow recency bias and base allocations on what has performed best recently:
- Many investors have developed a bias that they should be heavily focused in large-cap growth due to recent historical performance. Over the course of history, this hasn’t always worked. There have been elongated time periods where specific asset classes perform better than others. But this always changes, and no one can predict when it does. In fact, small-cap stocks have historically performed best on an average annualized basis since the inception of the stock market.
3) Diversification is necessary for an efficient portfolio:
Look at a diversified portfolio (the yellow shaded box within the Columbia Threadneedle quilt chart). Over the course of ten years, it provides a more stabilized/predictable return. It’s never the top performer but it’s also never at the bottom. It’s consistent. This can be the key to managing risk and volatility.
NOTE: In this illustration, a diversified portfolio includes stocks and bonds. Overall expected return is greater in stock asset classes than a diversified portfolio that includes bonds. Due to this, you can see that annualized returns of a diversified portfolio are nowhere near the top when looking at average annualized returns on the right column. But this principle stands when comparing stock-only asset classes or bond-only asset classes. You can expect to see less volatility year-over-year (return fluctuations) when diversifying among like-kind asset classes. This ultimately leads to greater return/risk trade off over the long-term.
For example, a diversified portfolio of all stocks outperformed the S&P 500, the U.S. large company asset class in which many refer to as "the market", over a 20-year time frame due to less return fluctuation/volatility. For reference, a diversified portfolio of all stocks will include small company stocks, mid-size company stocks, large size company stocks, international stocks, emerging market stocks, real estate, private companies, etc.
I know I bounced around a lot here, but I can’t stress enough how important diversification is. I hope this helps and feel free to reach out with questions.
1. Modern Portfolio Theory: What MPT Is and How Investors Use It (investopedia.com)
Read more articles by Ryan Johnson