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May 21, 2012

Do you understand the importance of “portfolio selection”?

Jeff Sommers’ May 19, 2012 article in The New York Times” discussed Facebook with Harry M. Markowitz.  Actually it was an article about investing.  “Mr. Markowitz, a 1990 Nobel laureate in economics, is the father of modern portfolio theory.   Mr. Sommers described Mr. Markowitz as follows: “…may have had a greater influence on current theories of finance and investing than any other livening person.”
Mr. Markowitz thinks that investors should put themselves in a position where the ups and downs of a stock should not matter.  His philosophy is that “Rational investors ought to assemble rigorously diversified portfolios of stocks and bonds with a mix of risk and return optimized for their own needs and beliefs.”
“Building diversified portfolios instead of hunting for hot stocks may not be revolutionary today -60 years latter – yet Facebook Frenzy in the air, the idea may be more important than ever.  “Markowitz’s most original contribution was his insistence on distinguishing between the riskiness of an individual stock and the riskiness of an entire portfolio.”  “…his theory …for unskilled investors without knowledge of the market:  forget about individual stocks… and buy broad low-cost stocks and bond index funds instead.  Allocate them in a proportion that gives you a level of volatility with which you are comfortable.”
“Understand that with more bonds and, presumably less risk, you may end up with a lower long-term return.”  The heart of his approach was understated in the article with his statement: “Rebalance periodically, and change the allocation if your needs or beliefs change.”  The allocation, portfolio selection, is the most important factor in investing.  The allocation does not remain fixed.  Among the many factors that will change are: living standards, life events, financial goals, health and geopolitical factors.  One advantage of reviewing your portfolio periodically is to identify the changes so that your allocation can be changed to reflect these changes.
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