Making Money and Sleep Well at Night

Earlier this year we wrote about Investment Performance and “league tables” in that article we talked about the concept of risk adjusted returns. http://shartruwealth.com/clients-area/articles/investment-performance-and-league-tables/

We said that risk adjusted returns was a story for another day.

To understand risk adjusted returns, we first need to understand the problem. In simple terms the investment problem is, we all like high returns and we don’t like poor returns. To quote our Chief Executive Officer, Rob Coyte, “all investors want high return, not risk, and nil tax”.

The investors wish, has a serious problems, first investment returns are a response to investment risk, in theory the more risk you take, the higher the return, so if there is no risk, there should by definition be little return. The next problem is tax. Investors pay tax because they have obtained a return. Without entering into merits of tax policy, a policy discussion our colleague Dr Hewson is leading with Dr Henry down at the Australian National University.

No withstanding the Doctor’s views, Mr Kerry Packer, said it most clearly when he said that “anyone who does not manage their tax need their head read”. While we won’t be discussing tax here we can help you with that problem too.

This article is not about tax either, it is about investment risk and how you manage it. Known as risk adjusted returns, its method of measuring and managing investment risk.

So here is the investment problem:

A friend says “I have been investing and making big profits from a legal investment, could I borrow $100, I need to make and investment and in returns I’ll give you 50% of the gains”.

Not a bad deal you think. So you give the friend $100, next day the friend gives you back a $1000.

Wow, the friend asks for another loan, so you give them $500, and strike a light, they give you back $5000 a few days later. A few investment later things start going bad, the big returns evaporate, infact so does your capital.

So you ask your friend, what has happened, we were doing really well. Your friend explains that they have been backing a horse at a regional track and it was doing really well, but now it’s not going so well.

The investment problem, like many other problems in life has a degree of randomness about them. Indeed, we have all tried the coin flipping game, which demonstrates that the more times we flip the more likely the total outcome will be 50/50. In the example above has number of issues. There is concentration risk, more money being placed on the same bet, the horses profile was becoming more recognised and the certainty the more times your race the more likely you are too loose.

So how do we deal with these problems in the investment world.

Prior to 1950’s, it was widely believed that investment assets values were random in nature. Therefore it was possible to analyse an asset based on its individual merits. Markowitz realised that this theory lacks an analysis of the impact of risk.

In the days of most mathematical calculations being done by pencil and paper, developing his theory was not easy. Markowitz believed that there was a mathematical relationship between share prices and therefore between asset classes.

In 1952 Markowitz joined the RAND Corporation, where he met George Dantzig. Dantzig whose legendry skills would form the basis for the introductory scene in the movie Good Will Hunting was a mathematical genius.

Many people have not heard of Dantzig, there is more about this remarkable man on our website. Dantzig developed the simplex algorithm which is vital for determining the best way to achieve outcomes, such as aircraft load factors or the most efficient manufacturing cost benefit. Known as linear programming Dantzig’s theories contained calculations that few people in the world could do effectively prior to the mid 1980’s. The advent of high speed computers changed this.

Once Markowitz met Dantzig he could bring together the pieces of his theory, and so in 1952 Harry Markowitz blew all previous investment theories out the window.

So revolutionary was his theory, that there was a correlation between share price movements the great economist Milton Friedman argued against Markowitz being awarded a PHD. Like linear programming models few could calculate the inter dependence of assets accurately until the late 1980’s. Despite all of that Markowitz was right and with advent of better computers, we can quite simply calculate what Markowitz was talking about.   In 1990, Harry Markowitz along with Merton Miller and William Sharpe won the Nobel Prize in Economic Sciences for the Theory.

Risk and return

Markowitz theory known as modern portfolio theory assumes that given two portfolios that offer the same expected return, investors will prefer the less risky one.

As such investors will only take on increased risk if compensated by higher expected returns.

Conversely, an investor who wants higher returns must accept additional risk. A rational investor is unlikely to invest in a portfolio if a second portfolio exists with a lower level of risk and similar returns.

Known as risk adjusted returns the theory uses historical prices and standard deviations to construct portfolios where by no added diversification can significantly lower a portfolio’s risk given a return expectation.

Risk

Markowitz uses standard deviation as the measure of price volatility and risk, treating them as the same thing. Simply Markowitz uses risk as the measure of the chances that an investment will go up and down in value, the oscillation between those ups and downs and by how much.

In Markowitz’s view risk comes in two major categories:

  • Market /systematic risk – the possibility that the entire market and economy will suffer losses affecting almost every investment;
  • unsystematic risk – the possibility that an investment or asset class will decline in value without having a major impact upon the entire market.

As the Global Financial Crisis demonstrated diversification does not protect against systematic failure as a collapse of the whole economy typically affects all investments.

Diversification does however reduce the risk of unsystematic risk, because the possibility that some assets may decrease in value is offset by having a portfolio invested in a variety of shares, property, bonds, which will help minimise total losses.

The Efficient Frontier

Markowitz developed a system to measure the inter relationship between asset classes using mathematical models. Known as the efficient frontier the chart below is an extract from our portfolio modelling tools that provides a high level example of what the efficient frontier equation looks like when plotted. The purpose of the efficient frontier is to maximise returns while minimising volatility.

You’ll note that the cash green box sits at zero. This is because this particular model takes account of inflation. The grey diamonds are specific asset classes be they shares or bonds. The coloured shapes are represent portfolios of differing weights of shares bonds and property. The black line is the efficient frontier. You’ll notice the efficient frontier line starts with lower expected risks and returns, and it moves upward to higher expected risks and returns. So people with different investment profiles as determined by their investment time horizon, tolerance for risk and personal preferences can find an appropriate portfolio anywhere along the efficient frontier line.

In a theoretical world the coloured shapes would sit on the black line. However we don’t live in a perfect world, so here is a real world illustration. You’ll also note that there comes where the line flattens and indeed falls. This is the point at which adding additional diversification reduces returns.

Portfolios along the efficient frontier should have higher returns than is typical, on average, for the level of risk the portfolio assumes. So in this case based on the model the Moderate portfolio is suboptimal. For practical reasons that may not be the case, but it is mathematically. This is why our advisers are skilled in balancing the theory with the real world reality.

Criticisms of Modern Portfolio Theory

Like most theories there are criticisms. Modern Portfolio Theory makes a number of assumptions that might not be reflected in the real world of investing:

  1. Taxes and transaction costs: Markowitz doesn’t take these into account.
  2. Investor’s access and can apply the same information: Nice idea, but unfortunately, this is just not true. Those with access to more information, or better information, can make different choices.
  3. Investors don’t influence prices:  The theory also assumes that investors act rationally. We know that is not always true. Investor sentiment can, indeed, influence prices, and often investors don’t act rationally and that can change market performance.
  4. Asset correlations are constant: One of the biggest criticisms of Markowitz’s theory is that asset correlations will remain the same. Of course that may not be the case.
  5. Volatility is constant: The theory relies on volatility being predictable, but its not. We have seen this illustrated during the global financial crisis. Additionally, the theory assumes that markets accurately price risk, when they actually don’t.

Like all theories real world events mean that no theory is perfect. Nevertheless the theory and its associated mathematical models provide a very powerful analytical base from which we can build client portfolios. Markets are not always efficiently priced, typically the greatest inefficiencies are in small capitalisation companies, and less efficient asset classes such as property.

We acknowledge that there are inefficiencies, “free lunches” in market prices. Undoubtedly spotting them requires more skill than most people have and that for the most part stocks are efficiently priced most of the time. Indeed preying on free lunches may see investors starve to death.

Market inefficiencies are best captured through regular investment and taking positions in markets when there has been severe market dislocation. We take those opportunities into account when building and managing client portfolios.

Accepting that past performance is not indicative of future performance, we use longer term historical data in our models and then supplement that data with forward estimates of market risk and performance. Statistically, the more data in the model, the less likely the historical results are to vary from the long term future performance.

As part of our asset allocation models our advisers seek to limit investment specific exposures, which limit exposure to any one investment.

Conclusion

Markowitz’s theory broadly explains the relationship between risk and reward and has laid the foundation for the management of portfolios. It focus the mind on the relationship between investments and diversification to create optimal portfolios and reduce risk.

Markowitz’s theory is significant today because demonstrates that volatility is most dangerous if the investment horizon is short and secondly diversification reduces risk. We couple that diversification with limits on exposure to individual investments, this intern strengthens the diversification.

Although the theory is not completely practical due to the limitations of its assumptions, but it provides a basis to value risk.

About Shartru Wealth

Shartru Wealth Management is the financial advice business within the Shartru Capital Group.

Shartru Wealth is Resi Home Loans joint venture partner in resi Financial Services.

Whether looking for the right investment strategy; advice on superannuation funds – including DIY Superannuation or Self-Managed Superannuation; personal insurance or how to get started with your first home loan, age care or estate planning – Shartru Wealth Management can help.

We work in partnership with our clients to provide financial advice to help you meet your individual financial goals and objectives.

We encourage our customers to build sustainable futures. That’s why we offer financial planning advice to ensure our customers prosper over the long term.

Shartru Wealth and resi Financial Services have points of representation in Sydney, Newcastle, Belmont, Bowral, Brisbane, Gold Coast, Melbourne and Perth

We look forward to welcoming you to Shartru Wealth Management.

Disclaimer: Written by Andrew Meakin Shartru Wealth Management Pty Ltd. ABN 46 158 536 871 AFSL 422409. The advice is general advice only and we have not considered your personal circumstances. Before making any decision on the basis of this advice you should consider if the advice is appropriate for you based on your particular circumstances.

About Shartru Wealth

Shartru Wealth Management is the financial advice business within the Shartru Capital Group.

Shartru Wealth is Resi Home Loans joint venture partner in resi Financial Services.

Whether looking for the right investment strategy; advice on superannuation funds – including DIY Superannuation or Self-Managed Superannuation; personal insurance or how to get started with your first home loan, age care or estate planning – Shartru Wealth Management can help.

We work in partnership with our clients to provide financial advice to help you meet your individual financial goals and objectives.

We encourage our customers to build sustainable futures. That’s why we offer financial planning advice to ensure our customers prosper over the long term.

Shartru Wealth and resi Financial Services have points of representation in Sydney, Newcastle, Belmont, Bowral, Brisbane, Gold Coast, Melbourne and Perth

We look forward to welcoming you to Shartru Wealth Management.