When it comes to asset allocation, one cannot overlook Harry Markowitz. His pioneering portfolio theory is hailed as “the most famous insight in modern financial history.”
Markowitz, who “peaked at his debut,” likely never imagined that a paper he wrote during the summer of his Ph.D. graduation in 1952 would not only earn him the 1990 Nobel Prize in Economics but also lay the foundation for asset allocation theory.
So, what lessons does this theory hold for ordinary investors? Today, let’s discuss the ideas of “Master Markowitz.”
The Wisdom of “Sacrifice” and “Gain”
In investing, people often focus their energy on selecting products. Setting aside the difficulty of choosing outstanding products from a vast array, successful investing cannot be approached solely from the perspective of returns.
Markowitz believed that investing is not merely an activity of pursuing maximum returns but also involves balancing the pursuit of investment returns with the risks they bring.
Returns and risks are often contradictory, like two sides of the same coin. Products with higher expected returns usually carry greater risks, while those with lower risks tend to offer lower expected returns. Therefore, balancing risk and return requires making trade-offs between the two, embodying a wisdom of “sacrifice” and “gain.”
Thus, scientific investing is not about blindly chasing high returns—which inevitably come with high risks—but about better balancing risk and return based on our individual circumstances.
So, the question arises: How can we achieve this?
In 1952, Markowitz innovatively used mathematical methods to define and measure the expected returns and risks of investments, proposing the use of diversified portfolios to balance risk and return.
This is what we now commonly refer to as asset allocation.
Allocation Using Asset Correlations
“Master Markowitz” believed that assets exhibit varying correlations, and combining different assets can achieve the goal of balancing risk and return.
What is the correlation between assets?
Take, for example, the CSI 300 Index, CSI 500 Index, and government bond index, which illustrate the price trends of three types of assets. The characteristics of assets moving “up or down together” or “oppositely” reflect their correlations.
Most of the time, stocks and bonds have low correlations. Allocating both can help smooth portfolio volatility and improve the investment experience.
By adjusting the allocation ratios of stocks and bonds, we can construct portfolios with different risk-return characteristics, providing us with richer investment choices.
