Chapter 9

Designing Taxable Investment Portfolios

Asset Allocation for the Private Investor

I was particularly struck by David Hume's argument that, though we release a ball a thousand times, and each time, it falls to the floor, we do not have a necessary proof that it will fall the thousand-and-first time.

—Harry Markowitz

The stock markets are a trap for logical investors because they are almost, but not quite, reasonable.

—Paraphrase of a remark by G. K. Chesterton¹

From earliest times, mankind has attempted to diversify the risks it faced. Shippers in ancient Egypt consigned their goods to several boats and sent them off at different times, presumably to avoid encountering the same storm (or perhaps the same pirates). In the Middle Ages traders sent their goods to the same destinations overland and by sea. The Rothschild dynasty's famously early and accurate news of world events (used by them to trade with very great effect²) was made possible in part because the family depended on more than one method of communication: fast, proprietary ships, but also couriers and even carrier pigeons.

In the first half of the twentieth century, modern investors intuitively understood the principle of diversification. We knew that owning two stocks rather than one would reduce our risk, and that owning 10 stocks would reduce risk still further. Moreover, we understood that owning both stocks and bonds would effect a dramatic reduction in risk, albeit at a similarly dramatic reduction in our returns.

But this was what we might call, in hindsight at least, “naive” diversification. It was naive because, while it often worked, investors misunderstood the underlying principle of diversification; namely, that what was important was not simply owning more than one security, but owning securities that are not perfectly correlated in their pricing behavior.

Consider investors who owned both Worldcom and Global Crossing—they fared little better than investors who owned one or the other of those hapless companies. Or consider investors who owned 10—or 50—dot-com stocks; they were clobbered in the tech collapse virtually as badly as if they had owned only one dot-com. Finally, as noted, investors who added bonds to their portfolios did indeed achieve risk reduction, but they also suffered a proportionate return reduction.