The theory that changed investing
In 1952, Harry Markowitz introduced Modern Portfolio Theory and, by doing so, changed the way that many investors viewed investing. This theory suggests that investors should consider how the risks and returns of individual investments can influence the outcome of their entire investment portfolio – a concept Markowitz demonstrated through the Efficient Portfolio Frontier1.
The frontier shows what happens to an investor’s portfolio when they combine investments from different asset classes. For example, when an investor adds stocks (up to 40% in this instance) to a portfolio of only bonds, it improves both the expected portfolio value and the worst-case portfolio value2 – showing investors that they can increase their returns and reduce risk at the same time.
The curve also indicates which combination of stocks and bonds results in the least risk – otherwise known as the efficient portfolio. In Markowitz’s example, the efficient portfolio consists of 60% bonds and 40% stocks. This assumes, however, that the investor is risk-averse. For risk-taking investors, a more attractive portfolio would be towards the right of the curve (from 40% stocks upwards). In addition, now that modern portfolios include more asset classes (not just stocks and bonds), the efficient portfolio changes as other asset classes are added.
What is the strategic asset allocation strategy?
An investment strategy that stemmed from Markowitz’s theory is strategic asset allocation. The main goal of the strategic asset allocation strategy is to create a balanced and resilient portfolio. To achieve this, investors choose a combination of investments that react differently to changing market conditions. How investors select each asset class and the allocation to each depends on their financial goals, time horizons, and appetite toward risk. However, with this strategy, one consideration remains constant: correlation.
Correlation measures how much (or how little) two asset classes follow each other in the same market conditions, for example, when interest or inflation rates rise.
If there’s a strong positive correlation between two asset classes, any peaks or drops in the market will affect both in the same way. However, when it comes to reducing portfolio risk, you want to choose assets that don’t react the same way, so only part of your portfolio is affected if there’s a downturn. Therefore, assets that have low or negative correlations can be ideal choices for strategic asset allocation. In Markowitz’s example, the reason risk reduces when you add stocks to a portfolio of bonds is because the correlation between the two is relatively low.
Correlation: the key to creating an optimal portfolio
As represented by Markowitz, the traditional portfolio allocation that was considered optimal (the highest expected return for the least amount of risk) was around 60% bonds and 40% stocks.
Correlations of traditional asset classes3
Example of an optimal portfolio with traditional asset classes3
Once put into place, investors often rebalance their strategically allocated portfolios periodically to keep the allocations consistent. This is because over time, the differences in the returns from each asset class can cause the initial allocations to unbalance.
Example of strategic asset allocation rebalancing
The value of alternative investments
In the current low-interest environment, assets such as bonds no longer provide the diversification benefits they used to1. So to combat this, investors are incorporating more alternative investments into their portfolios because of the low or negative correlations they tend to have with traditional investments1.
An example of an alternative asset class providing more effective diversification benefits is loans. The loans asset class has only slight correlations with traditional investments with values ranging from -0.13 to 0.44.
Correlations between loan-based retail investments and other investments1
Because of these low correlations, when added to a traditional portfolio of stocks and bonds, loan-based retail investments (regardless of proportion) significantly improved portfolio risk4. These benefits increased even further for loan investments purchased on the Mintos because of the 60-day buyback obligation4.
Correlations when loans added to traditional portfolio4
As well as reducing risk, loan-based retail investments can also increase overall portfolio value4. As demonstrated below, when the percentage of loan investments added to a portfolio increases from 5% to 20%, the overall portfolio value significantly increases.
Value development of European portfolios including loan-based retail investments4
When it comes to more modern portfolios that include ETFs (for example), loan-based retail investments still provide diversification benefits due to the low or negative correlations5, demonstrating that loans can be a valuable addition to both traditional and modern investment portfolios4.
As alternative asset classes such as loans gain momentum, so do the opportunities for investors to optimize their returns using strategic asset allocation. However, with this strategy, choosing asset classes that align with your investment goals, time horizons, and risk appetite remains important. Read more about the value of setting investment goals.
- Marot, E., Fernandez, G., Carrick, J. & Hsi, J. (2017) Journal of Applied Business and Economics 19(2): Investing in online peer to peer loans: A platform for alpha
- Markowitz, H. (1952) Journal of Finance: Portfolio Selection
- Bekkers, N., Doeswijk, R. Q., & Lam, T. W. (2009) The Journal of Wealth Management 12(3): Strategic Asset Allocation: Determining the Optimal Portfolio with Ten Asset Classes
- Aue, T. G. (2020) Do P2P Loans provide Diversification Benefits in Multi-Asset Portfolios?
- Livingston, L. S. (2019) Global Conference on Business and Finance Proceedings 14(1): Skewness, cryptocurrency, and peer-to-peer loans: and asset allocation exercise for a unique student-managed fund