The foundation of sound investing – achieving the proper balance between risk and reward – seem so obvious it’s hard to imagine a time when financial advisors weren’t preaching the gospel of diversification.
The science of asset allocation began in the 1950s with an economics student at the University of Chicago. Harry Markowitz would later go on to earn a Nobel Prize in Economics in 1990 and is now known as the father of modern portfolio theory. He currently serves on the faculty of the Rady School of Business at the University of California San Diego.
The idea came to Markowitz as he was sitting in the library researching ideas for his PhD dissertation: “I thought to myself, clearly investors want an expected return, but they don’t want too much variability of the return. That’s why there is diversification—to reduce variability,” Markowitz told SFO Magazine in July 2008. “In other words, the volatility of the portfolio depends not only on the volatility of the constituents but on whether they go up or down together. So I had two things: risk and return.”
The revolutionary idea – that investors should consider risk as well as return – is now used by millions of Americans when they balance their portfolios by spreading their assets over numerous investment classes and subclasses.
“The world is still uncertain and you have to diversify,” Markowitz told the Rady Business Journal 2010. “Academic studies have demonstrated that much of investor returns can be explained by asset class selection and weighting.”
Markowitz recommends the average investor diversify among a broad selection of cash and bonds, and advocates the use of low-cost mutual funds and exchange traded funds as a means to diversify.
“It is still important to have the right mix of fixed income and equity to construct a portfolio that considers your time horizon, risk tolerance, liquidity situation, tax consequences and any other unusual circumstances,” he said in the Rady Business Journal.