Self-Directed IRA Investing

In 1952 Harry Markowitz, then a University of Chicago economics student, published his doctoral thesis. It is considered so important to the world of investing, that economists consider the time before 1952 as BHM (before Harry Markowitz). In fact, he received the Nobel prize for Economics in 1990 for formulating what is now called the Modern Portfolio Theory (MPT). As CEO of PENSCO Trust Company, I frequently speak to financial advisors on the benefits of self directed IRA investing and discuss the benefits of Markowitz’s theory.

Why is this MPT so important? Because it’s an approach to reduce the overall risk of a portfolio while maximizing the potential for gain. Far be it for me to espouse on the complete details and differential calculus used prove his theorem. I’d rather remind people of some of Markowitz’s basic tenets which often get overlooked or confused.

First, is the assumption that all investors prefer to avoid risk. He defines risk as a deviation of the returns that the investor expects to receive. If you purchase a 3% CD, 99.9 of 100 times you will receive a return of 3% (e.g., no deviation, no risk). That is probably why a lot of people who are adverse to risk, or who want to escape a volatile stock market, will shift their portfolios into cash and/or CDs. If you buy the stock of a high-tech startup, on the other hand, and expect 500% return and receive 0% (because the company burns and crashes in its third year (think dot.bomb)), this is risk. However, rather than thinking of risk on an individual investment level, Markowitz suggests that you consider risk at the portfolio level, and that by combining risky investments with not so risky investments (e.g., diversifying), you reduce the overall risk of the portfolio while increasing the potential for positive returns.

How does this work? Well, another element of his theorem is very important and that is “correlation”, or how one investment relates to another. If you buy two mid-cap stocks, they will move in value similarly and, therefore, be “correlated”. On the other hand, if you invest in two companies dependent on corn and the price of corn goes up, the grower may do well, but the company raising cattle with corn feed may not. These companies are “not”, or “negatively” correlated. Markowitz contends that you get better diversification and returns if you have two non or relatively uncorrelated assets than two correlated assets in your portfolio.

Apparently, the U.S. Government agrees. The plethora of initiatives proposed and approved over the past few years in the pension arena have been aimed at releasing the shackles imposed by the majority of pension plans that have locked participants into a small family of mutual funds. During the period from 2000-2005, approximately $1.7 trillion in individual retirement account and pension fund value was lost with the general downturn in the market. While choosing different mutual funds (e.g., some invested in different industries) is a form of diversification, as many found out the hard way, doing so is not diversification in a pure sense, because they are all in the same asset class (e.g., mutual funds). Markowitz defined 21 assets classes (e.g., cash, Large Cap, Mid-Cap, money market funds, T-bills, domestic real estate, foreign real estate, foreign equity, long-term bonds, commodities, gold, etc.). Some of these asset classes correlate better with each other than do others. For example, Common Stock-Large Cap has a correlation of .801 (1.0 the highest) with Common Stock-Mid Cap. That means if the value of a Large Cap stock goes up, in general, so will the value of a Small Cap. On the other hand, a Large Cap stock has a low correlation with a Mortgage based REIT (.243). So, according to Markowitz, from a risk/return standpoint, you are better off having a REIT and a Large Cap stock in your portfolio than Large and Small Cap stocks.

When you read the financial papers today or watch the investor related TV commercials, pay attention to how often terms “diversification” and “asset allocation” are used. There is only one problem. Most continue to be promulgated by firms that restrict investments to securities. A portfolio consisting only of a mixed bag of securities will not help to mitigate “systematic” risk; that is, risk resulting from a rise or fall of interest rates or caused by wars, etc, events that generally effect the entire stock market. A mixed securities portfolio does help to reduce “specific” risk, which is the risk inherent in each investment.

However, further risk reduction and greater performance results can be achieved by adding asset classes that do not correlate with the stock market (e.g., commodities, cash, real estate). Remember don’t shoot the messenger, blame Mr. Markowitz. But consider this. If you had invested half of your portfolio in real estate over the past five years, you not only would probably not have lost value in your retirement portfolios, but would probably have experienced a substantial net gain. Markowitz felt that for every level of return there is one portfolio that offers the lowest level of risk, and vice versa. He defined this combination as the “efficient frontier”. Here’s hoping you happy returns, and may your investments find their efficient frontier!