Modern portfolio theory is no longer so modern. First articulated by Harry Markowitz in 1952, the concept of spreading investment risk by building a portfolio of investments to maximize returns while minimizing risk levels has become the grizzled 60-year old standard of Wall Street. The concept is that by choosing a variety of financial instruments with different returns and maturities, and different risk levels, you minimize the chances that what’s in your portfolio will rise or fall in tandem. In other words, the amount of correlation among your assets will be low.
There have been many academic studies that have tweaked the original Markowitz equations, and there have been a plethora of new investment vehicles, making it both easier and more difficult to build a relatively non- correlated portfolio. It’s easier because there is vastly more data available, and it’s more difficult because the differences among investment categories are increasingly minute and now represent a spectrum of choices instead of extremes. Nevertheless, there is still no basic criticism with the concept of diversifying your assets. While there are some who believe that diversification is not a good strategy – those who follow Mark Twain’s dictum to “put all of your eggs in one basket and then watch the basket closely” – they are a minority among investment strategists.
While there is nothing wrong with diversifying your portfolio, perhaps it’s time to rethink how we diversify. The conventional wisdom was that you bought bonds for safe steady income, stocks for income and growth, and that everything else was sort of speculative. In the 1970s, when global inflation was rampant, what was considered speculative – art, furniture, carpets, collectibles and precious metals – was suddenly renamed “hard assets” and given a place in portfolios as well. But should portfolios really be only about assets? Shouldn’t they be about the time horizon of the investor and the risk level attendant with owning any given asset over time?
The fact is, all investors have a time horizon implicit in their decision-making, and all investments are time-bound. Bonds are priced according to time both in duration and in yield – the longer the bond, generally, the lower the yield. Even stocks are time-sensitive, in a way: They are said to “discount the future” based upon news available today. If you look at investments in a time- bounded way, what once looked safe and sound now appears far less so.
The past is no longer a land of constancy. It is now a land of mistakes, and therefore, the place where risks are highest. We think of bonds as generally stable vehicles, but in fact they have become among the riskiest investments precisely because they are a reflection of all the poor spending decisions that have not worked out, whether it is social allocation in the form of government bonds meant to fund pensions or large projects that somehow never paid off, what the Italians charmingly call “cathedrals in the desert,” or corporate bonds by companies that were using debt not as a strategy for growth but as one for paying off existing investors at the expense of future earnings – the sort of thing that companies like Bain Capital and Goldman Sachs did expertly over the past two decades. Putting your money into investments that reflect the past is sort of like buying minefields for farmland: When you are plowing up the ground, you never know when a bit of ordinance is going to go off. Bond issuers default; bond holders rebel, and everybody looks for another way to kick their problems down an ever-lengthening road. Bonds are increasingly the province of lawyers and workout specialists, and are no longer for the faint of heart.
Investing in the present isn’t much better than putting your money on the past. Despite the daily gyrations of the equity markets, there are no solid truths on which you can hang your hat. Every rumor, every bit of news, becomes fuel for speculation, which make some people who are adept at riding the wave of chatter very wealthy, but leave most of us discomfited and constantly wondering if we’ve missed out on something important. Large institutions advise their clients to “hold for the long haul,” yet their own traders do no such thing, and are in fact paid large bonuses for their ability to exploit the volatility that roils markets. Occasionally, as the current Barclays Libor scandal demonstrates, stirring up the market will even go well beyond what is legal.
The problem with investing in the present is that what looks terrific in the present can look like junk a month or two later. Best current example? Facebook, which some astute analysts predict will not even exist within five years, but which rode a wave of hype to the detriment of many investors. Investing in the present ought to mean investing in companies that have sustainable positions in their industries and in the psyche of the buying public, but always with the knowledge that as Annie sings, “tomorrow is only a day away.”
Are the least risky and sanest investments always the ones just down the road? Could be. While bubbles of enthusiasm can overwhelm a trend and lead to endless me-too companies fighting over who will dominate “the next big thing,” staying abreast of trends is a great way to find investments that will pay off for years to come. Increasingly, there are better and better tools for vetting new enterprises. Would-be entrepreneurs have to run a heavy gantlet of bankers, VCs, incubator operators and lawyers, whose most important job seems to be throwing cold water on somebody’s idea of progress. In a competitive capital environment, it’s mostly the best ideas that get through. That’s not to say that the path to the future isn’t littered with investment failures. It’s just that with technologies like crowd-sourced research coming to the fore, it is increasingly possible to know in advance with some degree of confidence how long the odds are that any given project is likely to be successful. Investing in the future is what has always generated the great fortunes, and is likely to remain so. With so much new technology and change coming to the forefront – knowledge now doubles every six months – knowing what will pan out and what will simply be panned is more difficult, but certainly not impossible.