Today I write about H. Markowitz, my favourite economist of all times. Back in 1993, I wrote my university thesis about a successful investment strategy for private clients based on his modern portfolio theory.
Harry M. Markowitz, the father of modern portfolio theory, is a legend in the investment world. He won the Nobel Prize in economics in 1990. He discovered that investors could increase their returns and reduce risk by properly diversifying their portfolios in stocks, bonds and cash. But he went even further and showed that a combination of highly risky investments with negative correlation can not only lead to much higher returns but at the same time significantly reduce risk. Modern portfolio theory recommends that you diversify with a balance of stocks and bonds and cash that’s suitable to your risk tolerance. Markowitz’s message is clear: It is important to have negative or at least noncorrelated investments that move in different directions. A good overall portfolio is not only a long list of good stocks and bonds. It has to be balanced, providing the investor with protections and opportunities with respect to a wide range of contingencies.
Markowitz’s main principles:
1. if you want to reduce risk and increase returns, diversify your portfolio in noncorrelated investments. Rebalance your portfolio every year. That means selling stocks that have outperformed and adding to stocks that have underperformed.
2. don’t try to time the market. Selling near the top and buying at the bottom are harder than you think. Cost averaging is the best way to go. The benefit of dollar-cost averaging is that when stocks are down temporarily, you end up buying more stock.
Sven Franssen