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Happy Birthday, Risk and Reward!

In the context of world history, humans are relative newcomers. The current version (a.k.a. Homo sapien, Latin for "wise man") has been around for just 130,000 years, strip-malling a planet 4.5 billion years old.

Given that perspective, several decades is just a dribble in the historical bucket. Yet I bet most folks think that anything more than 50 years old couldn't be considered "modern." After all, how many people can still relate to The Honeymooners, which debuted in 1952?

There is one innovation from 1952, however, that is just as relevant today. That innovation is "modern portfolio theory," which was first laid out by Dr. Harry Markowitz in a 15-page article published in the March 1952 issue of the Journal of Finance. That was just the beginning for Markowitz, who was awarded the Nobel Prize in Economics in 1990 along with Merton Miller and Bill Sharpe.

Even though the theory was first articulated when Harry Truman was president, it still deserves its "modern" moniker, because it continues to be the foundation of millions of portfolios. Every worker who arranged her 401(k) with the help of an asset allocation pie chart, every retiree whose nest egg was saved by having a mix of uncorrelated investments, every investor in a "balanced" or "life-cycle" or "target retirement" mutual fund should send Markowitz a birthday card. But you better hurry, because today Harry Markowitz turns a very modern 80 years old.

To appreciate the importance of Markowitz's work, consider the state of stock investing in the early 1950s, as described by Peter Bernstein in Capital Ideas:

Only one in 16 adults owned any shares [compared to approximately one-half today], and the number of brokerage offices was still 20% below what it had been in 1929. After 23 years, stock prices were still one-third their 1929 peak. Stock ownership was considered so risky that the stocks of some of the best companies were paying dividends nearly three times the interest being paid on savings accounts.

On the occasion of his birthday, and after an interesting few weeks in the stock market, it is only fitting to highlight five lessons from the life and work of Dr. Harry M. Markowitz.

1. Read outside the box
Markowitz didn't start out with an interest in economics. Rather, he read widely, and was led to economics through philosophy and other subjects. As Markowitz wrote in his autobiography on the Nobel website:

In late grammar school and throughout high school I enjoyed popular accounts of physics and astronomy. In high school I also began to read original works of serious philosophers. I was particularly struck by David Hume's argument that, though we release a ball a thousand times, and each time, it falls to the floor, we do not have a necessary proof that it will fall the thousand-and-first time. I also read The Origin of Species and was moved by Darwin's marshalling of facts and careful consideration of possible objections.

This reminds me of one of my favorite quotes from Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) Co-Chairman Charlie Munger: "In my whole life, I have known no wise people who didn't read all the time -- none, zero. You'd be amazed at how much Warren [Buffett] reads -- at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out."

2. Nothing ventured, little gained
You don't get paid much to be safe. According to Ibbotson Associates, since 1926, intermediate-term U.S. government bonds -- among the safest investments in the world -- have earned an annualized 5.3%, while large-company stocks have earned a compound average 10.4% a year. One dollar in each of those investments in 1926 would have grown to $64.64 and $3,077.33, respectively, by the end of 2006.

3. Risk isn't just a four-letter word
Who wouldn't want to shoot for 10.4% instead of 5.3%? Someone who knows that stocks don't always win.

In case anyone needed a reminder after the 2000 to 2002 bear market, these last several weeks have demonstrated that what goes up might eventually come down. Here's a chart I published recently in my Rule Your Retirement service, featuring several Vanguard mutual funds ranked according to worst one-month return:

Vanguard Fund

1-Month Return

5-Year Return

Real Estate Investment Trusts Index Fund (FUND:VGSIX)

(12.6%)

17.7%

Small Cap Index Fund (FUND:NAESX)

(12.2%)

16.1%

Total Intl. Stock Market Index Fund (FUND:VGTSX)

(11.5%)

19.5%

Total Stock Market Index Fund (FUND:VTSMX)

(9.7%)

11.7%

500 Index Fund (FUND:VFINX)

(9.2%)

10.5%

High-Yield Corporate Bond Fund (FUND:VWEHX)

(1.8%)

8.7%

Total Bond Market Index Fund (FUND:VBMFX)

1.3%

4.1%

Short-Term Bond Index Fund (FUND:VBISX)

1.4%

3.4%

Intermediate-Term Bond Index Fund (FUND:VBIIX)

1.9%

4.9%

Source: Morningstar (data through Aug. 15).

Notice how the investments with the worst one-month returns tend to also be the investments with the better five-year returns. There's no golden rule in investing, and one month's returns don't tell a whole story, but the best assets of the past few years often suffer the most when people get jittery.

4. Focus on the whole, not the parts
Mokowitz's solution to aiming for a decent return while mitigating risk is to create a portfolio out of investments that don't march to the beat of the same drummer, at least not exactly. When one thing is zigging, another is zagging -- or at least not zigging as much. As Markowitz wrote in his 1959 book Portfolio Selection: Efficient Diversification of Investments, "A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies."

To give a quick illustration, consider the returns of five types of equities from 1972 to 2006, as well as a five-asset portfolio comprised of 20% of each and rebalanced annually:

1972-2006

Large Caps

Small Caps

REITs

Inter-
national

Commodities

5-Asset Portfolio

Compound Annual Growth Rate

11.4%

15.0%

13.9%

11.7%

11.2%

14.0%

Standard Deviation

17.2%

22.5%

16.8%

22.0%

24.9%

11.9%

Large caps and small caps from Ibbotson Associates; REITs from NAREIT index; international from Europe, Australasia, and Far East Index; commodities from Goldman Sachs Commodity Index.

The well-diversified portfolio ranked second in terms of return, but with a much lower standard deviation, a common measure of volatility. Plus, even though small-cap stocks had a higher annualized return over these 35 years, the multi-asset portfolio beat small caps in most of the consecutive five-year periods (i.e., 1972-1976, 1977-1981, et al.). I think most investors would find that rather appealing.

However, such a portfolio means that an investor must be comfortable with an investment (or a few investments) not performing so well at any given time; you have to live with the zags as well as the zigs. To quote Louis Stanasolovich, founder of Legend Financial Advisors and contributor to Retirement Income Redesigned, "If you're not losing money somewhere in your portfolio, you're not diversified enough."

(I should note that this isn't a portfolio that Markowitz, or too many other people, would actually recommend -- but it sure beats chasing the hot asset classes and getting burned.)

5. Never retire
This may seem like an odd lesson to highlight for the editor of The Motley Fool's Rule Your Retirement newsletter. But I've heard from enough retirees -- and ex-retirees -- to know that retirement can be a boring, lonely existence if you don't have a plan for how to spend your time as well as your money. Many of my retired subscribers live very exciting lives; our recent issue featured the story of a subscriber who traveled with his wife from Texas to Niagara Falls and back on their new motorcycle.

Yet many folks never fully retire, instead finding a way to continue working with more flexibility -- perhaps part-time, or part-year. But that doesn't mean they don't contribute to their 401(k)s or, more important, don't have a financial plan. In fact, working beyond traditional retirement age presents its own challenges, with the need to coordinate work income, Social Security benefits, pension payments, and required minimum distributions from retirement accounts.

As for Markowitz, he's a faculty member at the University of California-San Diego. Peter Bernstein tells us in the recently published follow-up (Capital Ideas Evolving) to his excellent 1992 book that Dr. Markowitz is still publishing and helping to develop a computer program called JLMSim, which conducts experiments by simulating market behavior given a range of inputs and participants (e.g., security analysts, portfolio managers, and traders).

Happy birthday, Harry!
Clearly, something created more than 50 years ago can still have a large impact today. After all, many things that came out in 1952 -- such as Cheez Whiz (made by Kraft (NYSE: KFT  ) ) and Vladimir Putin (made by Maria Ivanovna Putina and Vladimir Spiridonovich Putin) -- are still relevant in 2007. Yet few have had the impact of Dr. Markowitz's article and subsequent work.

So I hope you'll join me in raising a cyber-glass and wishing a happy 80th birthday to Harry M. Markowitz, a true "wise man."

Robert Brokamp is the editor of The Motley Fool's Rule Your Retirement service, which you can take for a free 30-day test drive by clicking here. Robert owns no stocks mentioned in this article. Berkshire Hathaway is a Stock Advisor and an Inside Value pick. Kraft is an Income Investor selection. The Fool has a disclosure policy.


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