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I n 1952, Harry Markowitz published "Portfolio Selection" in theJournal of Finance (Markowitz [1952]). It was the first article to present the concepts that are now known as modern portfolio theory (MPT). The premise of MPT-that portfolio optimization is a function of the average return and variance (i.e., risk) of the portfolio-is well understood by investors today. The main insight of MPT is that by estimating risk and return characteristics of the investments in their portfolio, as well as the correlations between the investments, investors can maximize return for a given level of risk or minimize risk for a targeted level of return (i.e., mean-variance optimization).
In addition to providing the first quantitative framework for portfolio allocation, MPT provided two important insights for investors. The first, that investment decisions should be made in the context of all other assets held in the portfolio, is an aspect of investment selection that may still be underappreciated by many investors. The second insight, that investors can reduce overall risk by diversifying their holdings, has been more widely accepted.
Of course, investors have long known that they should diversify their holdings. In the fourth century, Rabbi Isaac Bar Aha proposed that one should have "a third in land, a third in merchandise, and a third ready at hand" (Babylonian Talmud). Markowitz added quantitative support and precision to the rabbi's fundamental insight 1,600 years later.
MPT has the added benefit of actually working in practice, at least over long horizons and in hindsight. Exhibit 1 illustrates the risk and return characteristics, between 1926 and 2014, of seven asset classes. The solid line is the efficient frontier, the set of efficient portfolios that would have maximized return for a given level of risk, during the period. Because the efficient frontier resides above the returns of all of the individual asset classes (with the exception of the extremes), diversifying a portfolio among assets would have increased the efficiency of the portfolio.
Exhibit 1
Long-Term Efficient Frontier, 1926-2014
Note: Data are as of December 31, 2014. Over long horizons, higher return has been commensurate with higher risk.
Sources: Morningstar, UBS Chief Investment Office Wealth Management Research.
[Figure omitted. See PDF]
However, there is a big difference between examining a hypothetical backward-looking...