Basic Investment Theory

The two most important elements of basic investment theory arfe Diversification and the Separation Theorem.

Diversification - Harry Markowitz

Diversification is important to help reduce portfolio risk and overall portfolio volatilty. The most important elements of diversification is that you diversify between asset that have got a good chance of a good return AND that you diversify between investments that are as uncorrelated as possible.

Most people do not diversify using commonsense.

At the 2012 Portfolio Construction ( https://portfolioconstructionforum.edu.au/ ) 2 key-note speakers discussed diversification. Michael Kitces ( https://www.kitces.com/ ) pointed out:

  • That most people implement Markowitz's theory on diversification, simply by diversifying widely between different asset classes. Kitces pointed out that, if you go back to the original paper written by Markowitz, Markowitz does indeed firstly ask investors to identify “different assets” (preferably ones that as as uncorrelated as possible), but then to apply judgement and only diversify between asset classes that have a reasonable chance of getting a good investment result.

    • In my discussion with Michael Kitces later, he agreed that there were only a few assets classes at the moment, that had attractive risk/return characteristics and therefore necessarily, this means that astute investors should have highly concentrated portfolios focused on these few good sectors.

    • Nick Bullmanhttps://check-risk.com/the-team-2/ ) also agreed that at times, proper application of Modern Portfolio Theory sometimes leads to very concentrated portfolios.

Bottom line: It never makes sense to diversify into assets or sectors that have a high probability of a negative return. Eg Valuations matter, secular market trends matter, private debt bubbles matter, house price bubbles matter.

 

For further discussion on this topic, you might refer to this discussion. http://puzzlefinancialadvice.com.au/M/Circulars/2012M08/120826_attachment_120826_Portfolio_Construction_conference_notes_VERY_IMPORTANT_re_Diversification.pdf

For diversification, how many assets in the ideal portfolio?

Separation Theorem - James Tobin

The Separation Theorem is important because it guides you to understand the following key things about portfolio construction:

  • That cash (including term deposits) are a key tool in helping you to manage the over portfolio risk and volatility.

  • That the management of overall portfolio risk and volatility is separate from the problem of diversifying between risky/volatile investments.

  • That the right mix of "risky" (i.e. volatile) invetsment is the right mix for both risk-averse and high-risk-taking investors, with overall portfolio volatility being managed by the level of cash in the portfolio.

This is a very good intellectual framework to using to begin systematically managing your portfolio. You might then wish to fine-tune this thinking in a number of ways.

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