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Modern Portfolio Theory

Raffa Wealth Managements' investment philosophy is firmly grounded in the academic principals of Modern Portfolio Theory. We employ an "asset class" based investment approach in an effort to deliver comprehensive market diversification at the lowest possible cost. We believe that this approach maximizes investment return potential while minimizing investment risk and volatility.

Risk and Return are Related

You can divide the history of investing in the U.S. into two periods: before and after 1952. That was the year Harry Markowitz, an economics student at the University of Chicago, published his groundbreaking doctoral thesis setting forth the Modern Portfolio Theory, for which he won the Nobel Prize in economics in 1990.

This pioneering work lead to the classification of securities by shared risk characteristics and introduced the asset classes that have become standard today (Large Cap, Small Cap, Value & Growth, etc.). The manner in which investors allocate their assets among these various classifications largely determines their expected return. The wonderful thing about this is that the asset allocation determines the expected return because of the precise risk exposures that result. Risk and return are inextricably linked — beware of any attempt to circumvent or fail to recognize this critical relationship.

So, what exactly does this mean for you? Simply, that when you hold a diversified portfolio and spread out your investments by asset class, you’re really just managing risk and return.  The result is a broadly and precisely diversified portfolio allocation with clear risk and return expectations.

The Market Works

A longstanding debate about the capital markets has been whether or not they are "efficient." The Efficient Market Hypothesis (EMH) is the basis for the body of academic work known as Modern Portfolio Theory, upon which the American Law Institute built its prudent investing guidelines for trust fiduciaries.

EMH states that markets quickly and accurately reflect available information, and are setting "fair" prices for buyer and seller. Inefficient markets, in contrast, would enable a savvy investor to exploit security prices that do not accurately reflect all available information or do not respond quickly to new information.

Few would argue either extreme — that markets are purely efficient or inefficient. But those who choose active management believe that markets are at least inefficient enough to make it worth the treasure hunt. They will pay the costs involved in attempting to find mispriced securities to buy and sell. We feel that markets are too efficient to allow investors to consistently overcome the costs involved in identifying potentially mispriced securities.

 

Our Conclusion

Thanks to Harry Markowitz, Eugene Fama, Ken French, and other pioneers of Modern Portfolio Theory, we have a powerful understanding of the risks for which investors are compensated and those for which they are not. Long term investors have been rewarded throughout history for the capital they supply commensurate with the risk they take. Speculation adds risk, costs, and uncertainly with no additional expected return.

By implementing this prudent, passive strategy we don't have to spend our time or your money chasing potentially mispriced securities. Instead, we can focus on strengthening relationships and completely understanding the unique circumstances that may ultimately lead you to a successful long term investment outcome. Specifically, we can focus our efforts on:

  • Defining and incorporating an appropriate amount of risk within your investments
  • Capturing as much of the market returns as possible given your objectives and tolerances
  • Minimizing costs that might otherwise detract from your returns
  • Systematically rebalancing your portfolio according to these guidelines
  • Spending time on more certain and productive endeavors, rather than trying to predict or
           react to every market fluctuation.
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