W. Scott Simon
This month, I’m delving into the origins of the fundamental, underlying premise of modern prudent fiduciary investing which, as noted in last month’s column, I think of, collectively, as the 1992 (and subsequent updates) Restatement (Third) of Trusts (Restatement) plus the 1994 Uniform Prudent Investor Act. In my view, investment fiduciaries as well as those who advise them–such as attorneys, accountants, and other professionals concerned with issues of fiduciary obligation and legal liability–should have some familiarity with this subject matter.
The Prefatory Note to the UPIA states the premise of modern prudent fiduciary investing: “The trade-off in all investing between risk and return is identified as the fiduciary’s central consideration.” Section 2(b) of the UPIA appears to mandate the use of a risk/return analysis: “A trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.” Commentary to section 2 of the UPIA adds: “[section 2(b) of the UPIA]…sounds the main theme of modern investment practice, sensitivity to the risk/return curve…Investment risk and return are strongly correlated.”
But where did this idea of the “central consideration” required of an investment fiduciary–legally responsible and liable for portfolio(s) under its care–come from? It’s rare in the history of human thought that the origin of an idea can be identified with any precision, but in this case, it can be.
The notion of a trade-off in portfolio risk and return formed in the mind of a young Ph.D. candidate in economics one day in 1950 as he was reading a book on finance in the library at the University of Chicago graduate school of business. That book, The Theory of Investment Value by John Burr Williams, was published in 1938 and was very influential in its time.
In his book, Williams contended that investors should invest in those stocks they think will produce maximum expected returns. Williams maintained that holding a large number of such stocks is equivalent to diversifying risk.
As he read Williams’ book, it struck the 23-year old Harry Markowitz that Williams’ approach to investing in stocks is one-dimensional. That is, Williams focused solely on return without taking risk into account. In addition to Markowitz’s belief that Williams’ notion of diversification didn’t account for risk, he also believed that the approach could actually be quite risky.
The “riskiness” of Williams’ notion of diversification came from the fact that stocks with maximum expected returns often have high covariance to each other.
“Covariance” describes how the prices of stocks move relative to each other in response to new information, also known as “news.” (News can include accurate and inaccurate information, and an incalculable number of other factors, such as rumors that all go into establishing the market price of a stock at a particular point in time.) The prices of “high” covariance stocks tend to move in the same direction at the same time.
Think of how a school of fish swimming together reacts to the “news” of a pebble that’s thrown into a lake: They all dart away together from the splash, in the same direction at the same time. The same is true of stocks with high covariance to each other in a portfolio: Their prices tend to move in the same direction at the same time in response to news.
Markowitz concluded from this that Williams’ idea of investing only in those stocks likely to produce maximum expected returns–and that have high covariance to each other– failed to take into account the desirability of diversification of risk. It wasn’t enough to simply own a lot of these stocks.
Markowitz’s notion of diversification, on the other hand, was radically different (for its time) from that of Williams, who epitomized the prevailing thinking of the time about diversification. Markowitz sought to diversify a portfolio with stocks that have low covariance to each other. The prices of “low” covariance stocks tend to move in different directions at the same time.
Think of how a bunch of cats reacts to the “news” of someone trying to shoo them away: Some of them run this way, some run that way, some of them hang around thinking that they’re going to get fed, and some just keep sleeping. It’s like, well, trying to herd cats. Cat owners know that cats typically don’t move together in the same direction at the same time.
The same is true of stocks with low covariance to each other in a portfolio: Their prices tend to move in different directions at the same time in response to news.
Williams, then, thought of diversification as investing in those stocks likely to produce maximum expected returns. But Markowitz thought of diversification as investing in those stocks that will reduce overall portfolio risk (variance of return), with the added bonus of enhancing portfolio expected return. In short, Williams focused only on return while Markowitz focused on both return and risk.
This led Markowitz to suggest in his seminal 15-page paper on portfolio theory published two years later in March 1952–a paper deemed so important it was later called the “Big Bang” of all modern finance by 1990 Nobel laureate Merton Miller–that his notion of diversification (which I think of as “rational diversification”) tends to promote “investment” behavior, while Williams’ notion of diversification (which I think of as “naive diversification”) tends to promote “speculative” behavior.
In my view, investors who invest in those stocks they think will produce maximum expected returns– without taking risk into consideration–are speculators, not investors. And fiduciaries–those responsible and liable for investing and managing other people’s money (whether they are trust fund babies, participants in governmental plans such as 403(b), 401(a) and 457(b) plans, participants in private corporate plans such as 401(k) plans, or nonprofits such as foundations and endowments)–cannot be speculators.
After consulting another book in the library that fateful day in 1950, Markowitz pulled out a piece of paper and drew a risk/return trade-off, equating a portfolio’s risk with variance of return (which encompasses both “bad” standard deviation measuring loss and, counterintuitively, “good” standard deviation measuring gain) and its expected return with mean value. This meant, for the first time ever, that someone provided a precise mathematical definition of investment risk and return, thereby allowing investors to diversify portfolio risk in a rational way.
Although diversification has been used to reduce risk since time immemorial, what was different on that day is that investors would henceforth be able to create “efficient” (or rational) portfolios designed to maximize return for a given level of risk, or minimize risk for a given level of return. Without realizing it, Markowitz had set out on a course that would change the nature of investing.
Markowitz showed in a very compelling way that fiduciaries acting on behalf of their beneficiaries must consciously think not only about return, but even more importantly about risk. This simple yet fundamental idea, ranking as one of the most crucial investment insights of the 20th century, led to the creation of an entire body of academic and empirical work describing the behavior of financial markets that came to be known as modern portfolio theory. Forty years later, it earned Markowitz the Nobel Memorial Prize in Economic Sciences and universal acknowledgment as the father of modern portfolio theory.
We need only look at history to see how insightful Markowitz was in 1950. In 1999, for example, a naive diversifier might have held many high tech stocks in their portfolio–stocks that “cheerleading” Wall Street investment analysts believed would produce maximum expected returns. These were “can’t miss” stocks that didn’t have any risk because they were always going to go up in value, right?
The problem with such naive portfolios is that their stocks have high covariance to each other, with their prices tending to move together at the same time like a school of fish. When the high tech industry melted down in 2000 and 2001, the performance of a portfolio holding many (or only) “can’t miss” technology stocks with high covariance to each other reacted the same way–by heading sharply south.
This readily demonstrates the great danger posed by naive diversification of portfolio risk that Harry Markowitz uncovered in his early 20s nearly 70 years ago. It also illustrates that even though fiduciaries must be sensitive to the risk/return trade-off, they have little (really, no) ability to manage portfolio return, but they do have the ability to manage portfolio risk. This notion and its consequences will be explored in next month’s column.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.