Bend it Like ….Markowitz

Intuitively we all know that venture capital (top right) is a high risk/high return proposition while bonds (bottom left) are more of a steady, but low payout vehicle. As the chart shows, the risk return tradeoff is theoretically pretty linear, meaning that you can draw a line from bonds to venture and the other asset classes will be on or close to that line. Put another way, there is no such thing as a free lunch, if you want higher returns, you have to accept more risk.  The theory continues that while there is no free lunch, there are ways to optimize the risk reward relationship, or bend the line a little (maybe a free drink with your paid lunch).  How?  By adding non correlated assets. The easiest way to illustrate the concept is in the chart above to notice that Yale’s expectations for Domestic Equities and Foreign Equity Developed call for the same return/volatility relationship.  So in theory an equity portfolio of 100% US would do the same as 100% Foreign Developed at the same volatility level.  However, imagine that while one market zigs on some days the other zags, but they if they both end up in the same place at the end of the year, a combined portfolio that had some international stocks along with the US portfolio would have a lower volatility level than a portfolio entirely in one market because the markets are not dependent on one another.  Graphically this would push the Domestic Equity/Foreign Equity bubble in the chart to the left, to reflect the lower volatility, and bow the risk/reward line a bit to the left.  The logic continues that with lower volatility in the equity component of the portfolio, a manager could increase the allocation to equities and come out with a higher return expectation for the same amount of risk by diversifying into foreign equities.  Consequntly, many institutions migrated to the 70/30 policy benchmark in the hopes of higher returns at the same level as volatility as the 60/40.