P ORTFOLIO THEORY CREATES NEW
INVESTMENT OPPORTUNITIES
by Paula H. Hogan
Advances in portfolio theory are creating bearing ability, and then invest the
new investment opportunities for retail remaining funds in low-risk assets such as
customers. This article reviews the key PAULA H. HOGAN, CFA, Treasury bills.
ideas of modern portfolio theory and their This was a major assault on the idea
effect on the retail investment industry. It CFP is a fee-only financial that investors could consistently beat the
concludes by showing how practitioners market by picking winning stocks.
can incorporate modern ideas of Sharpe's model suggests that the market is
planner in Milwaukee,
investment management into client efficient and that the research-gathering
portfolios and thus produce portfolios and extra transaction costs incurred why
consistent with current investment Wisconsin, and president of stock-picking activities cannot be
knowledge. expected to yield superior investment
the Wisconsin chapter of the performance. According to this view, a
stock's price quickly reflects all known
information about its value. Only
American Association of
B efore 1952, investment managers unanticipated information would cause the
focused mainly on the selection of stock to deviate from its expected
individual securities. stocks Individual Investors. performance. Obviously, such
deemed safe were allocated to widows and unanticipated information frequently
children while riskier stocks were reserved occurs, but it occurs randomly and is
for wealthier investors, assumed to be equally likely to he negative or positive.
capable of bearing greater uncertainty. As a result. an investor cannot predict
There were no sophisticated measures of future price changes, and thus cannot
portfolio performance, and investment Problems for Practitioners reliably discern winning stocks in
services were sold mainly on the strength advance.
of client relationships. This concept caused problems for prac-
That began to change in early 1952, titioners. Who could sort through all the Academic or Real World?
when economist Harry Markowitz possible combinations of assets to find the
introduced a revolutionary concept: the portfolios with the highest expected return Of course, this theory depends on some
risk of a portfolio depends not on the for each level of risk? In the early l960s, important assumptions,. namely that each
individual risk of each investment, but on William Sharpe came to their aid. His investor has the same risk aversion,
how all securities in the portfolio behave idea, leading to another Nobel Prize. knowledge, tax situation,. and time hori-
together. Markowitz's ideas earned him a identified the stock market in toto as the zon. These assumptions are so academic
Nobel Prize and made obsolete the old most efficient equity portfolio. According
approach of "buy blue chip stocks for to Sharpe's Capital Asset Pricing model,
conservative clients." His ideas created a no other combination of stocks can offer
an expected return higher than the The odds of an investor
new goal of money management: the
construction of portfolios that produce the market's return at that particular market betting early and big on a
highest expected return for a desired level level of risk.(2) He argued that if there high-performance fund, and
of risk. With this theoretical advance came was a portfolio of securities offering a thus actually gaining the
the idea that even widows and orphans return higher than the market at only a
above-market return, are
should have some volatile securities in market level of risk, then the natural
forces of supply and demand would force extremely low.
their portfolios. Diversification--the idea
of assembling a variety of assets that the price of those securities hack in line.
perform differently from each other Sharpe concluded that the optimal way to that we may reasonably question the
instead of a portfolio of similar construct a portfolio is to choose an model's relevance to individual investors.
performing investments--became the appropriate level of risk,. invest in the Interestingly, though practitioners have
essence of portfolio construction. market portfolio to the extent of this risk- widely and heatedly debated the
January 1994 35
correctness of this efficient-market theory, In the 1980s, index funds became assets are well diversified and that the risk
many studies have documented the fact available to the retail market, either of the portfolio matches the risk of the
that money managers have not been able directly to consumers or through the beneficiary. including risk of loss of
to consistently beat the market. (3) inclusion of index funds in 401(k) options principal and of loss of purchasing power.
If active managers cannot beat the for employees. They are widely available This new standard for fiduciaries will be a
market, what do they do? There are two to individual investors at low-cost for potent tool for persons trying to promote
possible answers: many market sectors. including small and change in a personal trust.
They assume a risk level different large capitalization, and domestic and
from the market’s, and therefore have
expected returns different from the
market.
Or they assume one of the slots in The major determinant of the variation in a portfolio’s return
a basically random distribution of stems from the sole decision of how to divide funds among the
outcomes.(4) various classes of assets: cash, bonds, and stocks.
For example, in the current universe
of over 3,000 mutual funds, one would
expect, on the basis of probability alone, international securities. While retail index Rise of Asset-Class Investing
that a few funds will perform well above funds comprise less than three percent of
average, including some over a period of the market, index funds and their market Meanwhile, as individual investors he-
several years, merely by chance. This is share are growing. The percentage of come accustomed to these modern ideas of
not to say that managers do not differ in equity assets in index funds in the portfolio management, new theories are
ability. But distinguishing a good money Morningstar database rose nine-fold in the being proposed in academic circles that
manager from a lucky manager takes last decade, from 0.23 in 1983 to 2.08 in may have Similarly profound effects on
about a decade or more of data to make a 1993. The flagship Vanguard S&P 500 how' individuals manage their personal
statistically correct decision.5 In either index fund has grown from a starting base investments. For example, in a recent
case, the odds of an investor betting early of zero in the mid-1970s to its current study, University of Chicago professors
and big on a high-performing fund, and rank as the 10th largest fund in the Ken French and Eugene Fama suggest that
thus actually gaining the above-market Morningstar datahase.7 Sharpe identified onIy one of three
return, are extremely low. This trickling down of academic fundamental determinants of a portfolio's
In the 1970s, pension fund managers notions of portfolio excellence is also seen total return.(10) Sharpe said the important
learned this lesson the hard way by failing in the proliferation of asset-allocation decision in a portfolio is how much of the
to outperform the market despite their products. In a widely quoted academic portfolio is invested in the stock market.
major expense of time and effort. In study. Brinson, Hood, and Beebower French and Fama add two other
response, some large pension funds show that the major determinant of the fundamental factors:
developed index funds, which are mutual variation in a portfolio's return stems from The representation in the portfo-
funds designed to replicate the risk and the sole decision of how to divide funds lio of small capitalization stocks (stocks
return of the market, initially defined as among the various classes of assets: cash, whose price times the number of shares
the Standard & Poor's 500 (S&P 500). In bonds, and stocks.8 This is in keeping outstanding is low)
this process, pension fund managers with the already cited academic theories The representation of value
discovered that index funds are suggesting that the benefit of focusing on stocks (stocks whose price is low relative
significantly cheaper than actively man- the mixture of securities, not on the to the stock's book value)
aged funds because indexing eliminates individual securities, for optimal portfolio Building on this theory. other re-
the expense of individual stock selection. construction, and on the notion that searchers are investigating the idea that
(It now appears that active management choosing a portfolio level of risk is the tilting a portfolio toward a focus of small
must outperform the market by about two first step in constructing a sound portfolio. cap and value stocks is most effectively
percent a year to make up for its relatively These academic ideas, along with a desire done with global instead of only domestic
higher transaction and management costs.) on the part of consumers for investments.11 With these notions
Today, indexing. or passive man- simplification, are the rationale behind circulating at the academic level, it is no
agement. is a standard part of the invest- these asset-allocation products. surprise that we are beginning to see retail
ment world. Institutional money managers Another example of academic theory investment products that are index funds
explicitly index roughly 30 percent of washing over into the real world is the with a small cap or value tilt, or a
their assets.6 A smaller percentage of recent introduction of the Prudent Investor combination, offered on a global basis.
money is “closet indexed”—actively Rule.(9) This change in trust law As passive management evolves into the
managed, though in fact it closely mirrors incorporates modern ideas of portfolio indexing of more precisely defined sectors
the market. theory into a new standard to which of the economy, we move away from the
trustees are held accountable. This stan- world of individual security selection into
Impact on the Individual Investor dard requires that trustees ensure that
36 Journal of Financial Planning
the more modern world of asset-class Risk,” Journal of Finance, Vol.
investing. Practitioners can pursue an asset-class XIX, No. 3, September 1964, pp.
investing strategy by using index mutual 425-442.
Effect of Changing Technology funds to gain an almost generic access to 3 Charles D. Ellis, Investment Policy
the various sectors of the capital markets. (Homewood, IL: Business One
Putting the ideas of asset-class investing This strategy has important cost and Irwin), 1993, as well as Gibson,
into practice requires sophisticated use of theoretical advantages for our clients. In Malkiel, and Bernstein references
technology. Advances in computer this context, practitioners recommending a cited below.
technology are transforming the world of 1950s boutique-style of security selection 4. B. G . Malkiel, A Random Walk
investment management, and in particular, operate at a severe disadvantage. How can Down Wall Street (New York: WW
trading methods. For example, index practitioners ensure that their advice is Norton), 1990, pp.156-185.
funds can reduce transaction costs by consistent with modern investment 5. Roger C. Gibson, Asset Allocation
processing large block trades through off- knowledge? (Homewood, IL: Business One
exchange, matching networks, often at a Think of your client's portfolio in Irwin) 1990, pp.14.
fraction of the cost levied by the more its entirety. Avoid focusing primarily on 6. Peter Bernstein, Capital Ideas: The
Improbable Origins of Modern Wall
Street, (New York: Maxwell
Macmillan International), 1992, pp.
Practitioners can pursue an asset-class investing strategy 247-9.
7. Statistical data provided by John
by using mutual funds to gain an almost generic access to Rekenthaler of Morningstar, Inc.
the various sectors of the capital markets. 8. Brinson, Hood, and Beebower.
"Determinants of Portfolio
Performance,” Financial Analysts
traditional exchanges. In more illiquid the selection of individual securities or Journal, July/August 1986, pp.39-
markets, such as the small stock area, a individual mutual funds. 43.
trade's market impact often is the most Focus instead on choosing an 9. The American Law Institute,
important portion of total transaction cost. appropriate risk level for the portfolio and Restatement of the Law Third,
Portfolio managers can reduce these costs invest in the more volatile sectors of the Prudent Investor Rule, Washington,
by bidding for large blocks of stock at market up to the level of this risk aversion. D.C., May 1990
discount prices. A good example of these When reviewing a portfolio, look 10. E.F. Fama and K.F. Kenneth, “The
trends is the trading desk at Dimensional for diversified exposures to a wide variety Cross-Section of Expected Stock Re-
Fund Advisors (DFA), a leading asset- of market sectors, including small and turns.” Journal of Finance, June
class investment manager. At DFA., large capitalization, growth and value, 1992, pp.427-65. See also AAII
portfolio managers sit in front of several domestic and international. A well- Journal, September 1992, p. 19.
computers loaded with huge databases of diversified portfolio probably has some 11. C. Capaul, I. Rowley, and William F.
financial information and showing real- individual investments which, on their Sharpe, “International Value and
time quotes in several markets. By own, may not he attractive to the client. Growth Stock Returns,” Financial
refining their use of these databases and Monitor implementation costs. Analysts Journal, January/February
positioning themselves as a major block To the extent you are buying a generic, 1993 pp 27-36.
trading house, DFA has been able to commodity-like product, the purchase
reduce trading costs to virtually zero, even decision should be influenced by price.
in the highly illiquid area of small Stay tuned for more change.
capitalization stocks. Technological developments and
Index funds have very low costs academic theories will continue to
because they use sophisticated trading advance the field of portfolio management
strategies and because they do not pay the and create new opportunities for our
high cost of gathering "predictive”. clients.
information about individual securities.
Operating expenses for actively managed
equity mutual funds often exceed 1.00 Footnotes
percent a year. while comparable costs for
index funds range from 0.20 percent for 1. Harry F. Markowitz, "Portfolio
major market indexes to about 0.65 Selection,” Journal of Finance, Vol.
percent for the more specialized niches VII, No. 1, March 1952, pp. 77-
like small stocks or international stocks. 2. William F. Sharpe, “Capital Asset
Prices: A Theory of Market
Asset-Class Investing Strategies Equilibrium Under Conditions of
January 1994 37
