Sharing his views on why diversification within investment portfolios is key and why Markowitz’ MPT still holds good today, Sheldon MacDonald, CIO at Marlborough, establishes the case for pragmatic portfolio management
In the early 1950s, in a dissertation initially thought too radical to qualify for a PhD in economics, Harry Markowitz first outlined in detail the advantages of diversifying investments across asset classes. His research marked the birth of what became known as Modern Portfolio Theory (MPT).
Subsequent studies built on this trailblazing work by exploring the benefits of diversifying within asset classes. They showed, for example, that in the realm of equities it’s unrealistic – and usually unwise – to think all stocks will exhibit the same behaviour at all times.
Fast-forward seven decades or so and it’s tempting to wonder whether this wealth of insights was ever assembled. We’re only now emerging from a curious period in which MPT has been at best quietly overlooked and at worst dismissed out of hand.
This is because over the course of the past two years, astonishingly, investing in a handful of businesses in a single sector has routinely been portrayed as de rigueur. Many investors have enthusiastically embraced this idea as the way forward.
Perhaps this is why the sudden failure of investment strategies rooted in non-diversification has occasioned so much surprise. It’s as if investors conditioned never to look beyond the allure of mega-cap tech titans could scarcely imagine their portfolios might one day hit a rough patch.
All in all, it has been quite a wake-up call. It has laid bare the fact that many market participants bought into a wholly unsustainable investment narrative that flew in the face of both experience and empiricism.
The bandwagon loses it wheels
The headline-grabbing performance of the world’s biggest technology companies was the investment story of 2023 and the first half of this year. As the bandwagon rumbled on, an increasing number of investors were blinded to diversification’s enduring significance.
It was frequently suggested anyone seeking healthy returns need search no further than the so-called “Magnificent Seven” – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. It was sometimes even argued that Microsoft and Nvidia alone would suffice.
These are great businesses, of course, and rational investors should have no qualms about holding any company whose attractions are obvious. There’s no point in going against the herd just for the sake of being contrarian.
Yet relying almost exclusively on these stocks was never going to play out in the long run, because asset allocation isn’t just a question of banking on relentless growth. Risk, correlations and other considerations should be vital contributors to portfolio construction.
Interestingly, this dynamic has played out even in products supposedly explicitly designed to provide broad market participation: index-tracking funds. As their stock prices rose, the Magnificent Seven’s weights in market indices kept going up – as did the funds tracking those indices. Many actively managed funds, because of their sound risk controls, were simply unable to hold as much of these companies as index-tracking funds, which outperformed and drew in more and more investors.
But these index-tracking funds have become victims of their own success. The bitter irony is that a stock’s weight in an index will reach its highest level precisely at the point where it starts to fall – so it’s passive investors who now find themselves suffering an outsized negative impact on performance.
A timely reminder of vastness and variety
The principal lesson here is straightforward enough. Sensibly diversifying investments across asset classes, sectors, regions, market capitalisations and individual stocks remains the most prudent protection against volatility, falling share prices and other shocks.
Relatedly, it’s important to recognise passive investing doesn’t invariably entail low risk. As recent events have shown, index-tracking funds’ constituents can become unhealthily concentrated – with potentially painful consequences.
As an active manager that specialises in investing in smaller companies, we’ve consistently warned against focusing on a tiny clique of mega-cap businesses centred on one theme. Such an approach is totally at odds with our own.
We firmly believe in the power of diversification. We’re also acutely aware that small-cap and mid-cap stocks have tended to outperform their larger-cap counterparts over time[1].
Big Tech’s wobble has been a timely reminder of these truths. As such, it ought to reignite wider interest in an investment universe whose vastness and variety have of late been too easily forsaken or forgotten.
The sphere of investing is more sophisticated, more complex and in many ways much more impressive than it was when MPT was born. Ultimately, though, what Markowitz first proposed nearly three quarters of a century ago still holds today – and investors shouldn’t lose sight of that.
Sheldon MacDonald is CIO at Marlborough.
[1] See, for example, Deutsche Numis: “Smaller Companies Index” – https://dbnumis.com/equities/deutsche-numis-indices#:~:text=Over%201955%2D2023%20the%20Deutsche,larger%20companies%20by%202.9%25%20p.a
