Greath Wealth -Investment Information & Services

The Science of Diversification

May 25th, 2009

Many thanks to everyone for your kind words about my summary.  Although we could spend a week or two on the above topic, I plan to cover it in just two days and then have a wrap up summary for all my posts to date.

Diversification.  Investors often think it’s merely a matter of not putting all your eggs in one basket.  While we don’t want to put all our eggs in one basket, we’d miss half the story if we stopped at that.  So how do we get at a highly sophisticated, quantitative topic in a short, fun and easy few minutes?  As usual, I’ll explain it with an analogy.

So where is the analogy from today?  Christian may like this, as it from the kitchen, where I know barely enough to be dangerous, which you’ll see in the next few paragraphs.

Diversifying One’s Diet

Although we all enjoy a well cooked meal, we’re going to start with the basics and move up.

Option 1:  No Diversification.  Imagine having a kitchen with nothing in it but flour and water.  It may sound terrible, but if you’re hungry enough, that flour and water, before it turns to glue, may taste pretty good.  Yes, if that’s all you get you’re likely to suffer from malnutrition after a while.  But for a period of time that flour and water will keep you from starving.  It may not be real tasty, but it’s better than nothing.

The comparison of this to investing is having a portfolio with one ingredient.  Surprisingly, it’s not that uncommon.  Maybe the single ingredient is a money market account, or stock in the company you work for.  Another possibility is having it all in real estate, or gold, or whatever may feel good at the moment.  You’re not going to starve, you may not go broke, but you’re far beyond the optimal investment mix.  It’s like trying to live on flour alone.

Option 2:  Several Kinds of the Same Thing.  This is the structure of many portfolios.  How?  They may contain five mutual funds or ten stocks, but they’re all different colors of the same thing.  For example, maybe one has five different mutual funds, but they’re all large cap value stock mutual funds.  Or, maybe one has ten stocks in their portfolio, but they’re all high-tech stocks.  Do you remember the .com bust in ~2002?

Investing this way, which is common, is like living on five different kinds of flour.  Maybe you have wheat flour, white flour, chinese flour and a couple of other types of flour, but it’s really all the same.  it may blend to a slightly different color and taste a bit different, but it’s still a case that will ultimately lead to malnutrition.

Option 3:  Random Ingredients.  With this option, imagine having a well stocked kitchen, but getting your meal prepared through a random selection of ingredients that are then cooked for a random amount of time.

For example, imagine tossing a tomato and peanut butter into a bowl and mixing it well.  Then you add some fresh chopped garlic and a dash of soy sauce.  After spooning this into an oven safe pan, we throw a piece of salmon into the blender, let it run for five minutes, pour it over the oven safe pan, set the oven for 467.3 degrees F and let the mix bake for 11.23 minutes.

This has to be good, right?  After all, we have good ingredients:  peanut butter, a tomato, a clove of fresh garlic, some soy sauce and fresh salmon to top it all off, literally.

The taste may be absolutely terrible.  However, you’re going to get a diet that’s at least somewhat balanced.  And if you’re hungry enough, it may even taste acceptably.  Who knows, maybe you’ll get lucky and it’ll end up being a random masterpiece.  But probably not…

This is similar to the most common type of portfolio I see, before I go to work with Nobel Prize winning tools.  The investor has random amounts of the available ingredients (investment options) that are thrown together.  The end result may be far from optimal, but it’ll likely keep them from starving.

Option 4:  Enter the Master Chef.  This time we put a well-trained, experienced chef in the well stocked kitchen and let him go to work.  By adding the right amounts of the right ingredients and cooking them for the right amount of time, he ends up with the optimal meal.  It’s not only nutritious; it also fits your particular taste and situation.

This is what someone can achieve with the right blend of science, software, experience and training.  What is the science and software piece of this?  It all started way back in the 1950s, when a future Nobel Prize winner (1992), Harry Markowitz, was working on his PhD thesis under another future Nobel Prize winner (1976), Milton Friedman.  And where were they doing their work?  You guessed it:  The University of Chicago…

Portfolio Optimization – Briefly

I won’t bore you by going into the quantitative part of this.  It gets complex, quick.  But let me say the young Harry Markowitz found that when you apply two mathematical tools called statistical covariance and linear programming he discovered the whole of a portfolio could be greater than the simple sum of its parts.

Again, I won’t get into the details, but if you look at stocks A and B on the risk/return graph below, you’d think that if you combined the two you’d get portfolio performance characteristics that lie on a straight line connecting the dots.  However, the world is not all straight lines, and if you combine the “right A” and the “right B” you can get a result that lies up and to the left of the straight line that connects stocks A and B.

Why is being up and to the left of the straight line something that justified, in part, Dr. Markowitz winning a Nobel Prize?  It’s really quite simple.  If you go straight up from the straight line connecting A and B without moving to the right (more risk), you get MORE return for the SAME amount of risk.  That’s COOL, it’s what every investor desires:  More return without increasing the risk.  YES!

What’s this called?  Mean Variance Optimization, or MVO for short.

Does it have a limit?  Yes.  The optimal mix lies on an optimal line that’s up and to the left, a line called the efficient frontier.  You can see an example of this line in comparison to common investment benchmarks on the second chart.

Limitations of MVO

Keep in mind that MVO is not a panacea.  And more specifically, we’re applying a mathematical tool to an economic/investment analysis problem.  Yes, it does have its limitations, which we’ll discuss briefly tomorrow, along with an actual example of how this stuff works.

But for now, we need to keep in mind that there is a scientific way to build an optimal portfolio to raise your return, reduce your risk and cut your costs.  That’s what we want.  And yes, it applies to the real world, which we’ll see an example of tomorrow.

Stay tuned, as we’ll have more fun before wrapping things up on Wednesday.

Thanks,

Rod

PS:  Now you know why Pam, who’s of Italian descent, does all the cooking in our house, while I’m left to do the investing.  We’re a good couple.