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 is used to create efficient portfolios.
- It argues that any given investment’s risks 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.
Modern Portfolio Theory: What MPT Is and How Investors Use It(1)
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 at the link below when discussing the power of diversification. Click on it/copy and paste to see what I'm referencing.
quilt_chart.pdf(columbiathreadneedleus.com)
It illustrates historical performance of different asset classes from 2013 to 2022. The specific year is listed at the top of each column ranging from 2013 on the far left to 2022 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.
As you can see on the graphic, specific asset class returns can fluctuate unpredictably over a year-to-year basis:
- Take emerging markets for example. From 2013- 2015, it was one of the worst 3 performing asset classes in each year. Then, it was the best performing asset class in 2017 followed by the worst in 2018.
- Now, look at the large growth asset class. It has had the best average annualized return over the course of 2013 to 2023. From 2019 through 2021, it performed the best. Then, it was the worst performing asset class in 2022. In 2023, it has performed the best again.
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 and mid-cap stocks have outperformed large caps over the last 25 years (see link below).
Isit Time To Reassess Your Focus on Large-Cap Stocks? (jpmorgan.com)2
- Often, we see investors “follow” the prior year best performing asset class and put all their money into that specific class. This can often lead to poor performance. The best performing asset class in a specific year is often one of the worst in the subsequent year. As I stated, this took place with emerging markets in 2017 to 2018, municipals in 2018 and 2019, and large growth in 2021 to 2022.
Why diversification is key:
Now, look at a diversified portfolio (the yellow shaded box). As you can see, over the course of ten years it provides a more stabilized/predictable return. It’s never at the top performer but it’s also never at the bottom. As illustrated, it’s more consistent and predictable. This can be the key to managing risk and volatility.
Note: In this illustration, a diversified portfolio includes stocks and bonds. So, overall expected return is expected to be greater in stock asset classes than a diversified portfolio. 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 risk/return tradeoff over the long-term.
Here is our investment philosophy in a nutshell:
- We use modern portfolio theory to construct portfolios with the goal of improving long-term returns given a specified level of risk.
- Our belief is that diversification improves long-term returns without taking on additional risk. We believe diversification is the key to managing volatility in a portfolio.
- We take a long-term approach to investing. We do not make decisions based on short-term market conditions or recency bias of best performing asset classes in recent history.
- We rebalance and make changes as we deem necessary. As the markets, economy, and portfolio allocations change, we make changes based on those factors.
Together, we can work to keep you on-track towards your financial goals.
Request a consultation with me to learn more.
Read more articles by Ryan Johnson