November 16, 2012
In 1952 Harry Markowitz made a discovery that would change investments theory for the next 60 years. In simple terms he noticed that when stocks go up bonds go down and when bonds go up stocks go down. So buy half stocks and half bonds and your portfolio will not have wild fluctuations. The stocks will be a counterweight to the bonds and the bonds will be a counterweight for the stocks. The result is that your portfolio will have a nice and steady increase. Diversifying your portfolio between stocks and bonds allowed you to decrease the risk without sacrificing return. Markowitz called this the “free lunch” of diversification.
Fast forward 60 years and we are in a completely different investment world. Stocks and bonds are extremely volatile and it turns out are highly correlated, meaning that they go up and down at the same time. The diversification that served investors so well for 60 years seem to be failing us. As a result, many investors are starting to doubt the Markowitz assertion that diversification is a “free lunch”. However, more astute investors see that the concept of diversification is still valid, but that having all their investments in the public market, whether stocks or bonds, is no longer diversified at all. Diversification now means that a portfolio should include both public and private market investments.While institutional investors have already switched to portfolios diversified among public and private market investments, most regular investors are in a traditional mix of stocks and bonds. This is primarily because financial advisors did not have access to private investments suitable for the regular investor. In 2010 this all changed and financial advisors are now able to include private market investments in their clients’ portfolios. This means that regular investors are able to achieve true diversification in their portfolios.
Do the experiment for yourself. Look at your own portfolio. Is it a traditional mix of stocks and bonds? If so, have the bonds protected you when stocks went down? Have the stocks protected you when bonds go down? If not, you might want to consider increasing the diversification of your portfolio. However, not all private market investments are created equal. You should consult with a professional licensed to carry private investments and registered with the securities commission.
Carl Brodie is a Certified Financial Planner and a close friend of PLAN’s. Carl will be hosting workshops where he will explain how private investments might fit into a portfolio. Contact him at email@example.com
for more information.