Posts tagged ‘efficient frontier’

Markowitz’s Five Dimensions of Risk

Eighty-two year old Harry Markowitz, 1990 Nobel Prize winner, is best known for his creation of Modern Portfolio Theory (MPT) in the 1950s. MPT elegantly combines mathematical variables such that investors can theoretically maximize returns while minimizing risk with the aid of diversification. Markowitz’s Efficient Frontier research eventually led to the future breakthrough of the Capital Asset Pricing Model (CAPM).

The Different Faces of Risk

Before we dive further into Markowitz’s dimensions of risk, let’s explore the definitions of the word “risk.” Just like the word “love” is interpreted differently by different people, so too does risk. To some, risk is defined as the probability of loss. To mathematicians, risk often means the historical volatility in returns as measured by standard deviation or Beta. For many individual investors, risk is frequently mischaracterized by emotions – risk is believed to be high after market collapse and low after extended market rallies (see also Wobbling Risk Tolerances article).

The Five Dimensions of Risk

With the procedural definitions of risk behind us, we can take a deeper look at risk from the eyes of Markowitz. Beyond the complex mathematical equations, Markowitz also understands risk from the practical investor’s standpoint.  In a recent Financial Advisor magazine article Markowitz reviews the five dimensions of risk exposure:

1)      Time Horizon

2)      Liquidity Needs

3)      Net Income

4)      Net Worth

5)      Investing Knowledge/Attitudes on Risk

 Rather than pay attention to these practical dimensions of individual risk tolerance, countless investors adjust their risk exposure (equity allocation) by speculating on the direction of the stock market, which usually means buying high and selling low at inopportune times.  Although it can be entertaining to guess the direction of the market, we all know market timing is a loser’s game in the long-run (see also Market Timing Treadmill article). Markowitz’s first four risk exposures are fairly straightforward, measurable factors, however the fifth exposure (“knowledge and attitude”) is much more difficult to measure. Determining risk attitude can be an arduous process if risk tolerance constantly wavers through the winds of market volatility.

The Double Whammy

Rather than becoming a nervous Nelly, constantly chomping on your finger nails, your investment focus should be on action, and the things you can control. The number one goal is simple….SAVE. How does one save? All one needs to do is spend less than they take in. Like dieting, saving is easy to understand, but difficult to execute. You can either make more money, spend less, or better yet… do both.

The Baby Boomers are not completely out of the woods, but the next generations (X, Y, Z, etc.) is even worse off because they face the “Double Whammy.” Not only are life expectancies continually increasing but the Social Security safety net is becoming bankrupt. Consider the average life expectancy was roughly 30 years old in 1900 and in developed countries today we stand at about 78 years. Some actuarial tables are peaking out at 120 years now (see also Brutal Reality to Aging Demographics). So when considering Markowitz’s risk exposure #1 (time horizon), it behooves you to calibrate your risk tolerance to match a realistic life expectancy (with some built-in cushion if modern medicine does a better job).

Taming the Wild Beast

Every investor’s risk profile is multi-dimensional and constantly evolving due to changes in Markowitz’s five risk exposures (time horizon, liquidity needs, net income, net worth, and knowledge/attitude).  Risk can be a wild animal difficult to tame, but if you can create a disciplined, systematic investment plan, you too can reach your financial goals without getting bitten by the numerous retirement hazards.

Read the complete Financial Advisor article on Harry Markowitz

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 25, 2010 at 11:10 pm 1 comment

One Size Does Not Fit All

42-17053038

When you go shopping for a pair of shoes or clothing what is the first thing you do? Do you put on a blindfold and feel for the right size? Probably not. Most people either get measured for their personal size or try on several different outfits or shoes. When it comes to investments, the average investor makes uninformed decisions and in many instances relies more on what other advisors recommend. Sometimes this advice is not in the best interest of the client. For example, some broker recommendations are designed to line their personal pockets with fees and/or commissions. In some cases the broker may try to unload unpopular product inventory that does not match the objectives and constraints of the client. Because of the structure of the industry, there can be some inherent conflicts of interest. As the famous adage goes, “You don’t ask a barber if you need a haircut.”

Tabulate Inventory

A more appropriate way of managing your investment portfolio is to first create a balance sheet (itemizing all your major assets and liabilities) individually or with the assistance of an advisor (see “What to Do” article) – I recommend a fee-only Registered Investment Advisor (RIA)* who has a fiduciary duty towards the client (i.e., legally obligated to work for the best interest of the client). Some of the other major factors to consider are your short-term and long-term income needs (liquidity important as well) and your risk tolerance.

Risk Appetites

The risk issue is especially thorny because the average investor appetite for risk changes over time. Typically there is also a significant difference between perceived risk and actual risk.

For many investors in the late 1990s, technology stocks seemed like a low risk investment and everyone from cab drivers to retired teachers wanted into the game at the exact worst (riskiest) time. Now, as we have just suffered through the so-called Great Recession, the risk pendulum has swung back in the opposite direction and many investors have piled into what historically has been perceived as low-risk investments (e.g., Treasuries, corporate bonds, CDs, and money market accounts). The problem with these apparently safe bets is that some of these securities have higher duration characteristics (higher price volatility due to interest rate changes) and other fixed income assets have higher long-term inflation risk.

Risk-Return Table

Source (6/30/09): Morningstar Encorr Analyzer (Ibbotson Associates) via State Street SPDR Presentation

A more objective way of looking at risk is by looking at the historical risk as measured by the standard deviation (volatility) of different asset classes over several time periods. Many investors forget risk measurements like standard deviation, duration, and beta are not static metrics and actually change over time.

Diversification Across Asset Classes Key

Efficient Frontier

Source: State Street Global Advisors (June 30, 2009)

Correlation, which measures the price relationship between different asset classes, increased dramatically across asset classes in 2008, as the global recession intensified. However, over longer periods of time important diversification benefits can be achieved with a proper mixture of risky and risk-free assets, as measured by the Efficient Frontier (above). Conceptually, an investor’s main goal should be to find an optimal portfolio on the edge of the frontier that coincides with their risk tolerance.

Tailor Portfolio to Changing Circumstances

BellyIn my practice, I continually run across clients or prospects that initially find themselves at the extreme ends of the risk spectrum. For example, I was confronted by an 80 year old retiree needing adequate income for living expenses, but improperly forced by their broker into 100% equities. On the flip side, I ran into a 40 year old who decided to allocate 100% of their retirement assets to fixed income securities because they are unsure of stocks. Both examples are inefficient in achieving their different investment objectives, yet there are even larger masses of the population suffering from similar issues.

Financial markets and client circumstances are constantly changing, so the objectives of the portfolio should be periodically revisited. One size does not fit all, so it’s important to construct the most efficient customized portfolio of assets that meets the objectives and constraints of the investor. Take it from me, I’m constantly re-tailoring my wardrobe (like my investments) to meet the needs of my ever-changing waistline.  

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

*DISCLOSURE: For disclosure purposes, Sidoxia Capital Management, LLC is a Registered Investment Advisor (RIA) certified in the State of California. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

November 10, 2009 at 2:00 am 2 comments


Receive Investing Caffeine blog posts by email.

Join 1,804 other followers

Meet Wade Slome, CFA, CFP®

More on Sidoxia Services

Recognition

Top Financial Advisor Blogs And Bloggers – Rankings From Nerd’s Eye View | Kitces.com

Wade on Twitter…

Error: Twitter did not respond. Please wait a few minutes and refresh this page.

Share this blog

Bookmark and Share

Subscribe to Blog RSS

Monthly Archives