Much has been written about investment management since the early days when Harry Markowitz was writing about risk and return in the 1950s.

By Steven Albrecht

86498611Doctor Markowitz identified the importance of interrelationships between all assets and the management of the entire portfolio. Following that initial landmark work, over the past 50 years, mountains of research and data analysis has taken place.

For most of the fifty years between 1960 and today, investment management went through great advances in the professionalism of the practice. Portfolio management transitioned from an unorganized intuitive judgment call based on experience, to one of complied statistics and theoretical models, each more advanced than the previous. At the same time, regulation over the industry increased at an ever increasing rate in an attempt to keep pace and contain the promises of magical models and theories that looked great on paper but, somehow did not deliver on promises, or worse came through with devastating results.

Throughout this period, great effort was expended on defining the best way to determine an investor’s objective, defining investment policy, developing complex strategies, focusing on asset allocation, determining ways to monitor market conditions, and setting rules for portfolio realignment schemes. Most of the work was done with an expectation that some systematic exploitation of the market would be possible by applying intellect and sophisticated algorithms. Unfortunately, most of the research ignored an important component of the investment process – the individual investor and especially, the income-oriented investor.

Investing your money is more than just a series of statistics or analysts’ reports that give you an idea on how or where to place your funds. It is the result of years of hard work and determination. It represents a part of the work of your life, the principals upon which you grew up and developed through life, experiences both good and bad, decisions made about careers, family, spending, saving, planning, and focus. It is also about what you expect to occur going forward, both in your personal life and the world. Investment decision-making is intertwined with your life as well as the world around you. An attempt to strictly sterilize it into numbers and formulas and ignore the individual is myopic.

In future articles we will discuss investment management for the income investor from a practical, realistic and useful perspective while questioning some of the industry jargon. For example, almost every academic text book and investment journal article will explain in the section on return and risk that, market “risk adverse investors (conservative) will and must accept a less than market rate of return in order to achieve a less than market risk”. Is this statement true? Not necessarily.

Let’s take an interesting look at this rather broad statement that almost every piece of investment literature has in the beginning description or placed very prominently within the diagrams of investment options. Generally, you will see a definition that bonds are higher risk than cash and stocks are higher risk than bonds. These two premises are the anchor of the far majority of investment literature provided to every investor. Statements are found throughout literature that risk and return are related such that higher returns cannot be expected unless higher risks are taken in the portfolio. If an investor remains invested in bonds the return will not be as great as an investor that invests in stocks. Are they sure?


Looking at the past five years of the bond market in the chart above we can see it has increased by 22%. The chart is showing the aggregate bond index in the green/red line. The aggregate bond index is a broad representation of the global bond market. The increase has been rather steady (low volatility). Comparing that to the large company stock market (DOW) we can see the stock market has declined 6% over the same period and experienced a much more turbulent ride. What happened to the higher risk is rewarded with higher returns?

Before risk and return can be effectively used, investing should start with defining what risks or adverse outcome is unacceptable for the investor, over different time periods, and expectations for the future and not just the statistics over the past 20 or 30 years. Additionally, an investor needs to understand what will be the emotional and financial strain to them of negative or lower than expected returns. What are the ranges of expectations given what circumstances? What are the probabilities of expected outcomes? What level is the safety position relative to the overall income and investment position?

Every investor needs to determine a financial resource level whereby basic comfort is provided. If this level is defined and secured, the uncertainty of risk and return time periods and market cycles is less disturbing.

We will talk about this safety position and much more in future articles. Until then, don’t get caught up in the higher risk means higher rewards misconception.