By Dr. Jason White
Director of Investments
Family Investment Center
In my most recent column for the Maryville, Mo., newspaper, I discussed the scientifically-proven, Nobel prize-winning method of investment management known as Modern Portfolio Theory (MPT). I use this time-tested approach religiously in managing about $60 million of client investments.
From a macro point of view, MPT has just two goals: maximize return and minimize risk. This is a tricky benchmark. Most of us recognize that risk and return are highly correlated. The more risky a particular investment, the more return investors demand as compensation for that higher risk.
While this relationship is sometimes hard to see in investment management, it is readily apparent in consumer finance. Let’s take mortgages as an example. Low risk borrowers, those with high credit scores, good salaries, reasonable levels of debt, long employment history, etc., borrow money at the lowest market interest rate. These borrowers are low risk, thus lenders earn a relatively low rate of return on loans to them.
Consider a second borrower who is a credit nightmare. High risk borrowers may be past due on credit card and other debt service payments. They may be unable, or unwilling, to hold down a job. They have low FICO credit scores. Maybe they have even declared bankruptcy previously.
Intuitively, we know that the second borrower is going to have to pay a much higher mortgage interest rate than the first, because there is a much higher level of risk associated with the loan.
The same risk and return characteristics can be observed in the market. Utility stocks, often referred to as “widow and orphan” investments because of the lower risk level associated with them, have smaller but steadier returns than a biotechnology company or a wildcat oil speculator.
So, in MPT investing, we rely heavily on the idea of asset diversification to maximize return while minimizing risk. We want to spread dollars across various market securities to develop a balanced investment “scorecard.” We want to own bonds, stocks and real assets most efficiently by using mutual funds. A general rule of thumb for the average risk tolerant investor is to own a percentage of bonds in his portfolio that is equal to his age, with 20 as a minimum and 80 as a maximum. Thus a 40-year old investor would allocate 40 percent of his portfolio in fixed income mutual funds and/or individual government, agency and corporate bonds.
Another 10 to 15 percent of the portfolio should be in diversified holdings of international stocks and bonds. These should be mid-to-large size firms in countries that do not have excessive political risk. For example, I am much more comfortable with a Brazilian firm than a Venezualan one because of the political risk from Hugo Chavez.
About 5 to 10 percent of the portfolio should be in real (commodity) assets like real estate, precious metals and natural resources.
The remaining 40 percent or so goes into diversified stock mutual funds. For our 40-year old average investor example, about half of the stock investment should be in an ultra-low cost S&P 500 index stock fund, with the remainder actively managed in the mid-size and small-size company space. I like to use managers who blend both value (bargain-hunting) and growth (momentum) strategies.
There you have it. A broadly diversified portfolio spread over multiple asset classes in safe markets all around the globe. Modern Portfolio Theory is the investment strategy that never falls out of favor!