You’ve got to look at the portfolio as a whole, not just position by position. And if you’re trying to reduce the volatility or uncertainty of your portfolio as a whole, then you need more than one security obviously, but you also need securities which don’t go up and down together.
— Harry Markowitz
Steve Nash played 18 seasons in the National Basketball Association (NBA), where he was an eight-time All-Star and a seven-time All-NBA selection. He was also a two-time NBA Most Valuable Player while playing for the Phoenix Suns. And in 2006 ESPN named him the ninth-greatest point guard of all time. If you look at his career statistics (other than his assists), in many ways they are pedestrian. Over his career he averaged 14.3 points and just three rebounds per game — though he did average 8.5 assists per game. Certainly, there are those with far gaudier statistics and whom many would consider better players.
The reason Nash won such accolades is that his contributions go well beyond his individual statistics, especially points and rebounds. Nash’s main contribution was that he made everyone around him a better player. This attribute is why Nash is generally considered the greatest point guard of his era. It also demonstrates why it is so important to not view a player’s value to the team only by his statistics. One needs to consider how the player impacts the team’s overall performance.
The same thing applies to investing. A common mistake made by investors and even professional advisors is to view an asset class’s returns and risk in isolation. Just as the only right way to consider the value of Steve Nash is to consider how his play impacts the entire team, the only right way to view an asset is to consider how its addition impacts the risk and return of the entire portfolio.
Modern Portfolio Theory
In 1990 Harry Markowitz was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to what became known as Modern Portfolio Theory. Markowitz demonstrated that one could add risky but low correlating assets to a portfolio and actually increase returns without increasing risk (or alternatively, reduce risk without reducing returns). The following example (using Vanguard’s popular index funds, the largest index funds in their respective categories) will demonstrate just how important it is to consider investments as a whole.
Using data at Portfolio Visualizer, from 1998 through 2020 the Vanguard 500 Index Fund (VFINX) returned 7.97 percent per annum, outperforming Vanguard’s Emerging Markets Index Fund (VEIEX), which returned 7.58 percent per annum. VFINX also experienced lower volatility of 15.4 percent (versus 23.1 percent). The result was that VFINX produced a Sharpe ratio (risk-adjusted return measure) of 0.45 versus 0.35 for VEIEX. Looking at the data, would you have wanted to have at least some allocation to emerging markets?
Despite including an allocation to the lower-returning and more volatile VEIEX, a portfolio of 90 percent VFINX/10 percent VEIEX, rebalanced annually, would have outperformed, returning 8.14 percent. And it would have done so while also producing a higher Sharpe ratio of 0.46. Perhaps surprisingly, a 20 percent allocation to VEIEX would have done even better, returning 8.27 percent with a 0.46 Sharpe ratio. A 30 percent allocation to VEIEX would have done better still, returning 8.35 percent with the same 0.45 Sharpe ratio. A 40 percent allocation would have increased returns further still, to 8.38 percent, with the same 0.45 Sharpe ratio. The portfolios that included an allocation to the lower-returning and more volatile emerging markets benefited from the imperfect correlation of returns (0.76) between the S&P 500 Index and the MSCI Emerging Markets Index.
John Ruskin was an author, poet and artist best known for his work as an art and social critic. His essays on art and architecture were influential in the Victorian and Edwardian eras. He stated: “Not only is there but one way of doing things rightly, but there is only one way of seeing them, and that is seeing the whole of them.” Ruskin’s advice applies to investing. There is only one right way to build a portfolio — by recognising that the risk and return of any asset class by itself should be irrelevant. The only thing that should matter is considering how the addition of an asset class impacts the risk and return of the entire portfolio.
It’s also important to remember that if markets are efficient (and the persistent failure of active managers to exploit inefficiencies, as evidenced in the annual SPIVA reports, demonstrates that they are highly, if not perfectly, efficient), all risky assets should have very similar risk-adjusted returns. And that argues for broad global diversification, avoiding the home country bias that leads so many investors to underweight non-domestic equities. The logical starting place for you to consider is the global market capitalisation.