Posts tagged ‘Harry Markowitz’

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

You and Your 401K are Not Alone

You have choices in how you manage your 401k.

You have choices when it comes to managing your 401k.

A large majority of individual investors watched their 401k retirement accounts crater throughout 2008 and the beginning of 2009. For some, prudently managing these accounts, while attempting to decipher historic, unimaginable events, proved to be a difficult challenge. Fortunately for investors there are alternatives beyond managing a narrow 401k menu of options by yourself.

One option to consider is the establishment of a Self Directed 401k account, sometimes called a Self Directed Brokerage Account (SDBA). This is an option offered by a minority of plan sponsors (employers) to their employees, so make sure to ask your human resources department if you are interested in exploring this selection. By opening a separate Self Directed 401k account at a third party brokerage firm the investor should have access to a broader set of investment options relative to traditional 401k offerings. The retirement plan documents may however limit investment choices to certain investment products, in part due to litigation concerns created by potentially poor plan participant decisions.  Increased trading and administrative charges are other potential costs to mull over.

Opening up one of these self directed accounts also avails a 401k investor to work with an outside advisor who can assist with managing the external brokerage account. Of course, nothing in life comes for free, so the individual will be paying the advisor for these services rather than managing the account solo.

Instead of creating a whole new external Self Directed account, 401k investors can also hire companies for personal 401k management advice in their existing accounts. One such firm, Financial Engines, made famous by its academic all-star founder Bill Sharpe, provides advice to investing participants for a fee, based on the dollar value of the account.

Financial Engines claims to work with more than 750 large employers (including 112 of the FORTUNE 500 and 8 of the FORTUNE 20) and 8 of the largest retirement plan providers serving the retirement market. The problem with services like these (including Guided Choice, also a brainchild of a finance guru – Harry Markowitz)  is that no matter how great the advice may be, the investor is stuck with the limited investment options provided by the employer on the 401k company menu.

Other players in the financial industry are swirling around to advise participants on a piece of this $3 trillion 401k U.S. retirement asset market (ICI 2007 estimate), including some brokerage and mutual fund companies, and even independent financial planners. Also, don’t forget if you ever leave an employer, you have the ability to roll over your 401k account into a personal IRA (Individual Retirement Account) – an account you fully control with a buffet of options.

Regardless of the money you may have lost or the amount of confusion you feel, realize that you are not alone (if you choose not to be). Make sure to contact the appropriate human resource professional in charge of retirement benefits, and discover your 401k options.

July 8, 2009 at 4:00 am 2 comments


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