One day in the early 1950s, a Ph.D. candidate in economics sat in the library at the University of Chicago. The young man, Harry Markowitz, was studying leading investment guides used by professional money managers. The guides seemed to recommend that an investor should invest in stocks with the highest expected return and ignore all the rest. After a while, it dawned on Markowitz that investors should consider risk as well as return.

It was a simple conclusion; however, it spawned one of the most important investment ideas of the 20th Century, and has generated a whole body of scholarly work known as "Modern Portfolio Theory". Thirty-eight years later it earned Markowitz a Nobel Prize in Economics. The fact that trillions of dollars around the globe are now invested and managed according to the principle proposed by Markowitz is testament to its central importance in the investment process. This revolutionary insight has not only transformed the investment world of corporate and government pension plans, insurance companies, banks and other large institutional investors, it has also changed the way individual investors invest.

Markowitz knew that no one had really tried to systematically understand the importance of risk in the investment process. Up to that time, investors had focused on an investment’s return, but if they believed it contained some arbitrary, undefined notion of risk, then the investment wasn’t included in the portfolio. Markowitz understood quite clearly that risk and return are related. After all, investors like return and want to increase it, and they dislike risk and want to reduce it. On that day in the library, Markowitz set out to show investors how they could improve their investment performance by optimizing trade-offs between risk and return.

Because it seems so obvious, it’s hard to appreciate how truly profound Markowitz’s idea was. Of course both risk and return should be considered. In spite of the evident nature of this idea, the investment media continues to spread the “good news” of returns, while downplaying the “bad news” of risk.

In Figure 11-2 you can see a 10-year annualized return of efficient index portfolios compared to the average mutual fund (the green X), the S&P 500, and the only 86 managers in the Morningstar database with 20 years of managing the same fund. Morningstar® Principia® risk data does not go beyond 10 years, so the chart is shown using the 10 years from 1995 to 2005. About 10 actively managed funds are shown to be more efficient than the line of index portfolios. That means they are in the top left quadrant above the colorful line of buttons. Keep in mind that to have selected those funds 20 years ago would have been a near impossible task. Hindsight is 20/20. But index portfolios are always a better choice because they are consistent in their strategies.

Figure 11-2

Diversification in investing refers to the process of spreading out risk. Let’s look at a single stock in an index versus the entire index as seen in Figure 11-3. Because of the random nature of risk, no one knows what is going to happen in the short term to a subset of stocks in the index.

Figure 11-3

A subset of the index would actually be another index altogether with different risk and return characteristics. .

As Harry Markowitz stated, there are protections and opportunities that come with diversification. Investors who maximize them through global diversification will likely achieve the best investment outcome in the long run. They will also enjoy te smoothest ride along the way.

Is your portfolio properly diversified to match your risk capacity? Find out with a visit to ifa.com. Take the Risk Capacity Survey. You will be matched with an Index Portfolio that's right for you. Or, if you would like to speak with one of IFA's Investment Advisor Representatives to learn how you can improve your diversification for risk-optimized returns, call 888 643-3133.