Single-digit millionaires have bigger portfolios to manage, and that requires a little more sophistication for the average investor. Plus, some of you may be considering becoming accredited investors; or are at the point where you decide you really need to know what your financial advisors are on about. A good place to start with that is Modern Portfolio Theory (MPT): even if you don’t understand it to an expert level, it at least helps you grasp what it is the typical financial advisor is trying to do with your assets. Here we go:
What is this MPT thing anyway?
MPT was developed by Harry Markowitz in 1952, and it was a huge breakthrough at the time. Prior to MPT, all the financial advice in the industry was akin to what grandma told you: save your money, don’t spend it, you’ll be fine.
Problem is, things were changing. In your grandparent’s day, it was possible for even regular bank accounts to be paying interest rates of four to six per cent. Today, the typical savings account struggles to even reach 1.5 per cent.
MPT changed up the equation, allowing investors to keep pace in a way besides “hoard money in banks like chipmunks and acorns.” MPT looked at the quantification of risk versus return in portfolios.
This birthed the concept called the efficient frontier.
The upper part of the curve is the efficient frontier; that’s where you’re getting the lowest possible level of risk, for your intended return.
A practical example: if you want a 2.6 per cent return, would you do it by:
- Investing in your cousin’s shady exotic animal parts business?
- Finding a stock or bond fund product that comes close?
- Suddenly realising you can get 2.6 per cent by just sticking it in your CPF?
Obviously the third is the best option of those three – while all of the options could net you 2.6 per cent, CPF does it at the lowest risk.
Note that sub-optimal portfolios (those at the bottom of the curve) may still deliver the intended returns – but they’re less ideal, as they take much greater risks to do so. Usually, portfolios that lack diversification (e.g., 90 per cent of the assets are just one expensive HDB flat) are going to be in this sub-optimal area.
In any case, a return of 2.6 per cent is too low, and most of us would target something higher. So if your desired financial goals require five per cent, then it’s not just about finding any old asset that nets you five per cent. With MPT, you want to build a portfolio that will hit five per cent, while also taking on the lowest level of risk required to obtain it.
Your wealth manager / financial advisor can walk your portfolio’s place on the charts, but hopefully you have a better sense of their intent now.
Now let’s look at some other related concepts
Again, you don’t need to be an expert in these, but grasping them helps you understand what your financial advisor is doing (and what you’re paying them for):
● Alpha
● Beta
● R-Squared
● Sharpe Ratio
1. Alpha
Alpha refers to returns over the expected amount, after adjusting for the level of risk taken to obtain it. Because we’ve discussed above, it’s not just how much you made, but how much risk you took to get it.
Otherwise someone who took a high-risk gamble, like spending their life savings on 4D tickets at one go but coincidentally winning, would count as a financial genius.
The Alpha component is what you’re paying the fund manager for, when it comes to products like unit trusts. For example, say we use the ST Index as a benchmark: if the STI delivered 1.3 per cent returns, but your fund managed to deliver 1.5 per cent, then the excess 0.2 per cent is the Alpha.
Alpha is usually viewed as a reflection of skilled fund management. If a fund cannot meet the benchmark, or even underperforms it, then what’s the point of paying the fund manager, right?
2. Beta
This is expressed as a number, such as 1.3 or 0.7. It’s a way to measure how sensitive the returns of a portfolio are, in relation to a benchmark.
So say the Beta of a portfolio is 1.3, and the underlying index is the ST Index. If the ST Index moves up, then the portfolio will move up 30 per cent higher; if it moves down, then the portfolio will fall by 30 per cent more.
If the Beta is below one, then the asset is less volatile or sensitive to the wider market. Beta can also be tracked for different assets, which helps your Financial Advisor work out the right mix for your portfolio. In general, they want assets with different Betas, to reach the aforementioned efficient frontier.
3. R-Squared
R-Squared shows how much an asset’s price movement is “explained” by the wider market. If we were to look at real estate prices in Singapore, for example, all your grandparents were property geniuses, because they managed to pick flats that appreciated several thousand times in value from the 1960’s.
But in reality, we know that all the flats appreciated by that much in general. So we know not to trust your in-laws when they insist you must buy a 5-room flat, because they succeeded with it. Their success came from the time policemen wore shorts, okay.
As with Beta, we use a number. An asset with a R-squared close to one has a strong relationship to the benchmark; it goes up or down almost exactly in tandem with the market. Conversely, an R-squared below one has a weaker link to the market or benchmark.
Assets with a low R-squared tend to be very unique (e.g., one-of-a-kind rare stamps or paintings), and may be picked precisely because they have weak correlations to the wider market.
4. Sharpe Ratio
This measures how well a portfolio is doing, in relation to the level of risk engendered. This is expressed as a number or percentage, but in general, the higher the better. A high Sharpe ratio suggests that the returns are being derived with less risk taken, which is where you want to be.
The Sharpe ratio matters for all the reasons we’ve been discussing above: consider a portfolio that has returns of seven per cent, and one that has returns of 11 per cent. The 11 per cent may be more attractive; but it’s useless to you if it’s way past your risk capacity, and ends up wiping out completely.
This is the tip of the iceberg, but at least you know the iceberg is there now
It’s up to you if you want to go deeper into this; but I do suggest you know enough to at least keep up with what your advisors are doing. At the very least, it’s vital to grasp the concept that it’s not just about the level of return, but securing the lowest risk required to obtain that return.
The fastest runner still loses the race, if they break an ankle midway.
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