The 40-Year Old Lesson

 

Once again, sage and timely advice echoes from Harry Markowitz, Nobel Prize winner and the highly regarded Father of Modern Portfolio Theory. Markowitz’s admonition about correlation’s intensifying impact on risk or volatility was inked some 40 years ago, but it seems hot off the press with respect to today’s market climate.  

Markowitz’s observations of the vulnerability of a highly correlated portfolio have played out in painful and rapid-fire succession, with many investors learning too late the destruction of concentration in stocks that all rise and fall together.

Investors who focused their investments in the financial sector have hemorrhaged their portfolios, for many, irretrievably. Investors in Washington Mutual and Lehman Brothers were wiped out. Fannie Mae plummeted from an annual high of $68/share to $1.50/share. An emergency federal bailout of AIG staved off a total collapse of that company, shares of which dropped from $70/share to about $4/share.

There are long and painful explanations as to why these seemingly stalwart companies have crumbled, in some cases, overnight. The events that set the dominoes in motion have been well chronicled, but few if any of the stories describing the hideous turn of events focus on the important lesson of risk — risk that the companies took and the risks that their investors took.

An absence of a fundamental understanding of the perils of excessive risk (not to mention excessive leverage) have driven companies and investors straight into an economic avalanche, the fallout of which has proven to be devastating. But, despite the fact that so many have lost so much, will they carry away the lesson that will ultimately prevent them from ever suffering like this again? IFA sincerely hopes so.

IFA continues its ongoing efforts to educate investors regarding the intrinsic relationship between risk, return, time and diversification. IFA’s mission is to change the way the world invests, and from the looks of what has transpired — the world desperately needs our help.

Reams of articles describe the impact the recent market downturn has had on excessively risky and highly correlated portfolios. Of particular concern are the losses of those approaching retirement age. Many such articles detail the angst that plagues investors who are now forced to rethink how they will retire. Clearly, no one ever showed them how much risk they were taking in their portfolios. It’s obvious that no one ever quantified the amount of risk that was right for them — their risk capacity. It’s pretty clear that no one ever advised them as to the importance of global diversification and investing across multiple asset classes. And now, many investors are learning too late that these factors are more than “nice to haves” — they are imperatives.

Throughout the recent market downturn, we have heard the endless mantra: “It’s different this time.” Indeed, we at IFA do hope it’s different this time. We hope that every investor will finally take the time to learn the importance of investing with risk in mind. We hope that every investor will learn that proper risk is the source of stock market returns. Harry Markowitz gave us this valuable information 40 years ago. Investors who have invested without consideration of his advice have been punished during substantial market downturns, while those who have heeded the call have been empowered to earn the returns that capitalism delivers. Ideally, those who have lost this time will not lose the lesson. Let’s definitely make it different this time.

Eighty years of stock market history tell us that the equity markets will resume their upward climb. The vast majority of the world’s businesses will earn profits and deliver returns to shareholders. The extent to which you can profit from global capitalism is determined by your risk capacity.

If you have not already done so, find out how much risk is right for you by taking the Risk Capacity Survey. By providing answers to either the 5-question or 25-question survey, you will be matched with an Index Portfolio that is globally diversified, fully transparent, and invests across as many as 15 different indexes that carry 80 years of risk and return data. This risk-appropriate asset allocation will enable you to invest with an understanding of your expected risk and return. This understanding will advance your peace of mind and your ability to plan for your retirement. This understanding will enable you to invest in an efficiently correlated, risk-calibrated and globally diversified portfolio that maximizes efficiency and returns at a given level of risk — the amount of risk that right for you.