Harry Markowitz, Nobel laureate in economics and a pioneer in investment theory suggested that a fundamental responsibility of any investor is to manage the risk of their portfolio. The risk he was referring to is volatility: the ups and downs of stock prices during the year and from year to year. Investors who ignore risk in pursuit of returns expose themselves to intolerable portfolio declines prompting them to abandon their plan thereby converting temporary losses into permanent ones. Conversely, those who choose to minimize or avoid volatility entirely must be willing to accept returns that may prove insufficient to fund their future goals.
The world’s capital markets are comprised of different asset classes each with their own risk and return characteristics. The three major categories are stocks, bonds and cash. A portfolio’s distribution across asset classes refers to its asset allocation. Sophisticated investors have known for decades that asset allocation is the most significant determinant of a portfolio’s performance. Landmark studies published in the 1980s and 1990s analyzed the returns of large institutional plans and confirmed the crucial role of asset allocation estimating that it explains more than 90% of a portfolio’s returns and volatility over time. The message for all investors is that asset allocation is far and away the most important part of designing a successful portfolio.
In general, stocks provide the growth engine for the portfolio. The higher the allocation to stocks the higher the expected investment returns and along with it the greater the volatility. Bonds, on the other hand, offer stability, but not much long-term growth potential especially after accounting for inflation.
The appropriate mix of stocks and bonds will strike a comfortable balance between growth and stability and reflect the individual investor’s financial goals and ability to handle risk. Investing is often framed as a choice between eating well as a result of high stock market returns and sleeping well from the stability that bonds provide. The implication is that investors must choose one or the other. Markowitz showed us that a sensible asset allocation allows us to do both.