The economist Harry Markowitz won a Nobel prize for his work on Modern Portfolio Theory (MPT). One of the core concepts of MPT is that diversifying an investment portfolio can change the overall risk/return profile of the portfolio as a whole. MPT can most easily be represented graphically. If one had a list of assets classes with expected returns and expected volatility, one would see the opportunity set represented below with returns on the y axis and risk/volatility on the x-axis. Venture capital at top right is high risk/high return while Fixed Income/Chase is bottom left representing the two extremes. Note: We used the Yale endowment’s estimates for the graph, the size of the bubbles representing Yale’s target allocation and the color to distinguish liquidity.
Intuitively we all know that venture capital is a high risk/high return proposition while bonds are more of a steady, but low payout vehicle. As the chart shows, the risk return tradeoff is theoretically pretty linear across asset classes, meaning that when you draw the line from bonds to venture capital, the other asset classes will be on or close to that line. Put another way, before MPT, the thought was that there is no such thing as a free lunch, if you want higher returns, you have to accept more risk. The MPT theory argues 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 have the same return as 100% Foreign Developed at the same volatility level. Therefore an investor should be indifferent about choosing to invest in U.S. or international stocks. 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 experienced lower volatility or lower risk than a portfolio entirely in one market because the markets are not completely dependent on one another. Graphically this would push a combined 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 adding other non correlated assets would also lower volatility and that there is an “efficient frontier” where you get the most bang for your buck, by optimizing the portfolio weights of the asset classes as can be seen in the Endowment Volatility Target level.