Risk Exposure

In the early 1950s, a young Harry Markowitz applied his mathematical expertise to investing. Markowitz, then a Ph.D. candidate in economics at the University of Chicago, believed investment professionals erred by urging investors to focus solely on returns of individual stocks with no consideration of the concept of risk exposure. He set out to reveal how investors could improve their stock market investing performance by optimizing the trade-off between risk and return. In his 1952 Nobel Prize-winning paper, “Portfolio Selection,”1 Markowitz established the importance of diversification. He asserted the best portfolios include non-correlated stocks that act and move independently from each other. Today, I estimate that trillions of dollars worldwide are invested according to his principles of risk and return, known collectively as Modern Portfolio Theory.

The blend of investments that is appropriate for a particular investor is known as asset allocation, also called risk exposure, and is based on an investor’s risk capacity. Asset allocation is the most important factor in optimizing a portfolio’s expected return, thus it is essentially the most important decision an individual investor can make. This concept also extends to larger institutional investments-such as state pension funds, fire and police pension plans, non-profit and for-profit defined contribution plans, church funds, college endowments, and any other funds governed by committees. 

As presented in Step 8, Nobel Prize-winner Eugene Fama and professor Kenneth French identified that as much as 96% of equity returns are explained by a portfolio’s exposure to market, size and value. Their research expanded upon Markowitz’s and Sharpe’s initial findings regarding risk and return. While Fama and French demonstrated that indexes constructed of small and value companies have historically outperformed the total market index over the long term, the risks associated with these small and value indexes have also been higher. 

    -1 Harry Markowitz, Portfolio Selection, The Journal of Finance, Vol. 7, No. 1. (Mar., 1952), pgs. 77-91.
Step 11IntroductionHarry MarkowitzModern Portfolio TheoryPortfolio SelectionDiversificationEugene FamaKenneth FrenchSharpe