KILDARE'S MAKING CENTS: You can blame Harry Markowitz

I WAS carrying out a review for a client of mine recently, where the pension fund I had recommended had grown in value over the past three years by €135,844.

And I had recommended three different funds to him back in 2021, and each invested in different asset classes, in different sectors, in different locations throughout the world.

One fund grew in value by +6.76%, the second grew in value by +17.12% and the third by +30.06%.

They were impressive returns, and he was delighted with the performance, but he did say to me, why didn’t we put everything into the third fund, the returns were incredible.

And my response was.

Blame, Harry Markowitz.

And you may not have heard of Harry Markowitz before, but he won a Nobel Prize in economic sciences in 1990 for what people said was his revolutionary approach to how people should invest in shares.

His basic advice which became known as modern portfolio theory, in layman’s terms meant ‘don’t put all your eggs in one basket’.

And that’s exactly what I did with my client.

You see up until the beginning of the millennia, the majority of people believed you had to invest in one, possibly two high growth companies if you wanted to make money. And of course the opposite was also true, because if you picked the wrong companies, you could lose everything.

Markowitz’s contention was that you could reduce that risk of wiping out your entire savings whilst still producing excellent returns if you invest in not just one or two stocks but in forty or perhaps even fifty. And you shouldn’t limit your investments to just investing in companies either, you should spread your risk further by investing in other asset classes like government and corporate bonds, property, cash, commodities and so on. With this type of approach you don’t have to get lucky and invest in unicorn type companies to produce great returns.

If we take my client as an example, if he invested everything only in the fund that produced the biggest return over the last three years, in 2022 his fund would have fallen in value by -18.86%.

And if he invested all of it in the lowest performing fund, he’d have seen its value fall in 2022 by -8.45%.

Now let’s look at what would have happened in 2023, because that was a much better year than 2022.

The higher risk fund delivered returns of +10.99% and the other fund was +5.61%.

So, by diversifying and having two funds that invested in different areas (as I said already, he actually had three), he lost less when markets fell in value but still took advantage when markets rebounded and increased, and that’s what you want with your pension or investment fund, and having a good spread of investments will help make that happen.

And why should you invest in different companies and in different asset classes? The answer is simple, it’s to reduce your risk.
And that’s because the value of shares in different companies don’t all move in the same direction i.e. in recessionary times some companies will perform much better than others, the same applies when inflation is high or low or when there are geopolitical issues to contend with which is why you should invest in companies involved in different sectors like technology, pharmaceutical, finance, consumer, energy, real estate, telecommunications etc.

And the same can be said for government and corporate bonds because when interest rates rise or fall the type of bond you have and the company or country it’s with and the duration of when it will be redeemed, all influence how much it’s worth at a point in time.

And because we don’t know what the future may hold in any of these instances with any degree of certainty, you have to hedge your bets and plan for those unexpected external events that could happen and which you have no control over.

This might sound difficult and complex, and it can be if you don’t have the knowledge or the time or the interest do look into this yourself, and if this applies to you, I’d reach out and get help just to make sure your money isn’t diversified too much or too little or not at all.

I’m sure people reading this who only invested in what once were considered blue chip Irish bank shares would agree with this advice, because back in 2008 they would have seen what for many was their hard-earned life savings, reduce in value by as much as 90%. People who perhaps at one point had €100,000 worth of shares, saw that value drop to just €10,000. And they never saw it coming and nobody really did, but its’ a lesson we must learn from and try protect ourselves from it ever happening again.

The same thing applies to people who have accumulated shares in one particular company and that company being the one they work for or worked for a long period of time.

And it might not have been intentional on their part, it just accumulated over time because they didn’t need to sell their shares or there was a strong performance with the company share price or they were familiar with the workings of the company as opposed to the fear of the unknown and investing in other companies or they wanted to invest in the company they worked for because they believed in its purpose/mission.

But now their company shares account for a disproportionate amount of all they have. And that makes them nervous and rightly so because it just takes one scandal or one product coming off patent or one accident or incident that could see their share price being severely impacted.

And I’m thinking specifically about a window of an Alaskan Airline falling out mid-flight recently, which saw Boeing’s share price take a tumble. So, lots of things can happen that we couldn’t foresee or even imagine could happen. And when that happens some people mistakenly spend more time thinking about what will happen if things go right, rather than thinking about what would happen if things go wrong and that’s where having a well-diversified fund that invests in many different companies and in different sectors helps.

This is probably very boring advice but it’s really important, trust me.

And if we were able to predict the future with certainty, we’d all be rich, and we wouldn’t have to worry about what companies or sectors we should invest in.

But most people understand that this is an impossible ask and the best way to admit that you have no idea how the future will unfold is by diversifying your investments, so they’re set up to react to any number of future possibilities i.e. wars, pandemics, high or low inflation, recessions etc.

And a good financial adviser should be honest and tell you that they too don’t have any certainty over which asset class is going to perform the best year on year, which is why I’m hoping they’ll tell you that investing across different asset classes is the best strategy. By doing this, you’re just covering all your bases.

And there will be some things you invest in that you wish you hadn’t and there are others you’ll be delighted that you did but that’s just how it is.

I remember hearing someone once say that investing comes down to regret minimization. And it stuck with me because I thought it was great because some people will regret missing out on big gains and others will regret having big losses, but having a well-diversified portfolio will help minimise both of these regrets.

And diversifying your investments doesn’t mean you’ll never lose money either, but it does help you from experiencing endless negative returns.

I’ll finish by saying that if you have a well-diversified portfolio, it will produce good returns for you, and whilst it may not deliver the extraordinary, it will avoid the terrible. And if that sounds good to you then I would review your existing investments or get someone to do it for you to make sure they’re set up the right way for you.

Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at liam@harmonics.ie or www.harmon5ics.ie