By Scott O’Brien, CFP

In the 1950s, a PhD student named Harry Markowitz was studying at the University of Chicago learning about economics and financial markets. 

At that time, investing in stocks was basically selecting companies thought to have high expected returns and then hope for the best. 

Markowitz thought there must be more to this process; that investors should take risk into consideration as well as return. Over the years he developed the Modern Portfolio Theory which talked about risk and return, and, in 1990, was awarded the Nobel Prize in economics for his work. 

He reportedly said, “They gave it to me for postulating that you shouldn’t put all your eggs in one basket.” And essentially, that’s what his research proved.

Asset allocation and diversification

With all the volatility in the markets in the past few years, Modern Portfolio Theory, along with asset allocation and diversification, has become a hot topic. But what do those terms really mean? 

Asset allocation is simply apportioning or splitting up your assets to different asset classes*, and diversification is balancing defensively by dividing funds among different securities, different industries, or different classes.**

By diversifying your portfolio, it should reduce the overall volatility. In other words, spread the risk. Keep in mind, while diversification may help reduce volatility, it does not protect against loss. 

The goal is to put together a portfolio of assets that doesn’t go up and down together at the same time (called negative correlation). When one investment zigs, the other zags. 

For example: Gold and stocks are thought to be negatively correlated asset classes. In general, when gold prices rise, stock prices fall. This phenomenon is due to inflation or inflation worries. Gold rises in an inflationary environment. 

Stocks, on the other hand, tend not to perform well in an inflationary environment because interest rates usually rise making bonds and CDs look more attractive for investors. 

Even within one asset class, diverging performance can occur. According to Morningstar, during the bear market of 2000-2002, the Center for Research in Security Prices (CRSP) Cap-Based Portfolio 10 Index — a capitalization-weighted benchmark of the smallest 10 percent if the NYSE’s listed equities — posted a cumulative 30 percent gain, compared with the S&P 500 Index’s near 40 percent loss. 

So by allocating your portfolio among diversified asset classes where in any environment you will likely have some winners and some losers, you reduce the volatility of the portfolio. As financial writer Nick Murray puts it, “Diversification is the conscious decision never to be able to make a killing, in return for the priceless blessing of never getting killed.” 

Solid financial advice

Good financial advisors are, if nothing else, good risk managers. When you sit down with a good financial advisor, he or she will ask a number of questions about your goals, assets, investments, insurance

protection, asset protection, risk tolerance, and long-term care plans. One must understand the risks they face to determine the course of action to take when planning someone’s future. 

In academic studies of investors, most investors tell the researcher one thing, but act differently. Investors say they are conservative, but when you perform a review of their portfolio they are in fact heavily concentrated in aggressive growth stocks or even worse heavily concentrated in their employers stock. 

The key to achieving acceptable results within your risk tolerance is to divide your assets in a manner that garners these returns within the framework of risk you are willing to accept. In the 1980s, researcher Gary Brinson and his colleagues published a study in the Financial Analysts Journal.

They determined that over 90 percent of one’s total portfolio return is based on the allocation of the portfolio — not market timing, not individual security selection, or other factors. So, if you had a 10 percent return as a target, 90 percent of that total 10 percent return is due to your allocation. 

Implementing a plan

When considering your asset allocation plan, it’s important to take into consideration all of your assets in and outside your retirement plan. Once you decide on the proper allocation, the next question becomes which investments should be in the various accounts you might have. 

For example: In today’s low capital gain and dividend tax rate environment, many financial advisors recommend keeping stocks in taxable accounts since capital gains and dividends are taxed up to a maximum rate of 15 percent (federal). Since income from corporate bonds and CDs are taxed at the ordinary tax rates that can go as high as 35 percent, depending on your tax bracket, financial advisors often recommend tax deferred accounts for these investments. Of course, you must also consider state taxes.

Proper planning could significantly lower your taxes and increase your after tax returns. It pays to carefully monitor any changes in the tax codes to readjust your current investments and any subsequent investments as the tax code invariably changes over time. 

Tax concerns should never be the overriding concern when investing, but it should be part of your investment strategy. Find a competent CFP, financial advisor, or tax professional to advise you. 

Perhaps it’s best to remember that Markowitz received his Nobel Prize for his work that said “don’t put all your eggs in one basket” — 12 eggs; 12 baskets.

Scott W. O’Brien, CFP, can be contacted at Azodi CPA & Investments, PC at 816-455-9100. Registered Representative of and securities offered through Berthel Fisher & Company Services Inc. (BFCFS) Member FINRA/SIPC. Azodi CPA & Investments, PC is independent of and not associated with BFCFS.

*Asset allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses. 

** Diversification cannot eliminate the risk of investment losses.