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Practical Implications of Investment Theory

 

Many investment principles used to develop investment portfolios derive from one investment theory — the capital asset pricing model.  What exactly is this theory, and how does it apply to your investments?

The capital asset pricing model was developed over 50 years ago by Harry Markowitz, who won a Nobel Prize for his work.  His theory centers on the concept that adding an asset to a portfolio that is not highly correlated with other assets in the portfolio can reduce the portfolio’s variation risk.  Before his theory, it was common practice to look for undervalued assets to add to a portfolio.  His approach evaluated how a particular asset would impact the portfolio’s risk and return.  Whether it makes sense to add that investment to the portfolio depends as much on how the asset’s return will vary with returns of other portfolio assets as on its own return prospects.

This theory provides the underlying rationale for asset allocation.  The key is that the returns of different assets do not behave in the same manner during different economic times, so adding different assets can reduce the volatility in that portfolio.  While the return of a diversified portfolio may be lower than that of investing solely in the best performing asset, that is typically viewed as an acceptable tradeoff for the reduced risk.  Many people have also realized that it is difficult to identify the best performing asset in any given year, so a diversified portfolio provides more consistent returns.

Some of the investment implications that have been drawn from this theory include:

•   A properly diversified portfolio will combine assets that do not have highly correlated returns.  Thus, when one asset is declining, other portfolio assets may be increasing or not decreasing as much.

•   Rather than focusing on each investment’s risk, investors should consider their portfolio’s overall risk.

•   Including a small percentage of a volatile investment may not increase a portfolio’s overall risk, provided that investment’s returns do not vary closely with other assets’ returns in the portfolio.

•   When small portions of stocks are added to an all bond portfolio, risk initially decreases, even though stocks are more volatile than bonds.  Thus, an all bond portfolio is not the lowest risk portfolio. 

•   Investors should consider how varying percentages of different asset classes will affect their portfolio’s risk and return before deciding on an asset allocation.

 

Managing Your Portfolio

  Consider this investment process to incorporate this theory:

•   Determine your risk/return preferences.  You should assess the potential downside as well as upside for various investments to get a feel for how much risk you can tolerate.

•   Decide on an asset allocation mix.  Your asset allocation strategy represents your personal decisions about how much of your portfolio should be allocated to various investment categories.  After considering your risk tolerance, time horizon for investing, and return needs, you can form a target asset allocation mix.  Within broad investment categories, make allocation decisions for each category.  Not only will each individual’s allocation strategy differ, but your strategy will vary over time.

•   Select individual investments.  Investigate a wide range of options, but make sure you understand the basics of each, examining the types of risk they are subject to as well as their historical rates of return.  Your selections should fit in with your overall asset allocation.

•   Rebalance periodically.  Over time, your asset allocation will stray from your desired allocation, due to varying rates of return on your investments.

Please call if you’d like to discuss your investment portfolio in more detail.

 

 
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