Financial Advice from Shakespeare (and others!)
By Pauline Shum Nolan, PhD, Co-founder and CEO
To students of finance, portfolio diversification is one of the most fundamental concepts in the discipline. Harry Markowitz, Nobel Laureate in Economic Sciences in 1990, is credited for operationalizing the concept using mathematical statistics. To fans of Shakespeare, the idea of diversification should not be foreign either, as Markowitz himself once pointed out, the Bard of Avon, in the Merchant of Venice (Act 1, Scene 1), wrote: “My ventures are not in one bottom trusted, nor to one place; nor is my whole estate upon the fortunes of this present year.”
In 1952, Markowitz pioneered research that showed how to diversify portfolios efficiently. The influence of his work can still be felt in the investment industry more than 60 years later. Let’s consider some basic principles of diversification. The goal of diversification is to reduce overall portfolio risk, usually with a given level of expected return in mind. Unlike the expected return of a portfolio, which is simply the weighted average of the expected returns of the individual securities in the portfolio, the risk of the portfolio is more complex. The risk of the portfolio, as measured by the volatility of the portfolio returns, is typically less than the weighted average of the risk of the individual securities. It is because some of the security price movements will offset each other to a certain degree. For example, when the price of oil drops, the energy stocks in your portfolio will suffer, but the transportation stocks may gain. Therefore, it is important to choose securities whose returns are not perfectly correlated; and the less so, the better. In addition, because transaction costs are incurred when trading securities, and there is a limit to how much risk can be diversified away, portfolios should also be built in a cost effective manner.
Interestingly, diversification could at times seem like a counter-intuitive idea. During the late 1990s, diversification was a tough sell. Any technology stock one bought on the Nasdaq would jump in price quickly, and investors felt that diversification would actually lower returns. (In fact, if you had a crystal ball, all you need is one stock – the one that yields the highest return in a given time period.) That phenomenon was, of course, short-lived, and the technology bubble eventually burst. It took the Nasdaq composite index almost 14 years to reach its previous peak. This example demonstrates that diversification is for longer term outcomes; in the short-term, anything can happen.
Another compelling example is the finance crisis of 2008. The bull market that led up to the crisis had many investors overweighed in stocks. When the U.S. stock market began to tumble, we witnessed a rapid transmission of shock from the U.S. to other stock markets around the world. Consequently, the benefits from geographical diversification disappeared, as correlation amongst global stock markets shot up during the crisis. This episode highlights the importance of diversification across asset classes, particularly for investors with a lower risk tolerance. For example, U.S. treasury bonds, which yield much lower returns than stocks over time, proved to be a valuable diversification tool. Treasuries (and the U.S. dollar) went up in price as a result of investors’ “flight to safety” during market turmoil.
So as it turns out, Shakespeare was not only a brilliant playwright, but also a very wise financial adviser. The lesson today is still the same - do not put all your eggs in one basket (unless you have a crystal ball!). If you are investing for the long haul, diversify, not just geographically, but also across global sectors and asset classes. Inexpensive index products have made diversification easier than ever for retail investors. Last but not least, there is no need to panic over short-term volatility.
"Diversification is for longer term outcomes; in the short-term, anything can happen."
“My ventures are not in one bottom trusted, nor to one place; nor is my whole estate upon the fortunes of this present year.”
Merchant of Venice (Act 1, Scene 1)