The Greatest Sharebroker Tip Of All Time

It was the early 1950s. A young PhD student at the University of Chicago was working on ideas for his PhD. He was waiting patiently in a lounge for a chance to talk to his dissertation adviser. Little did he know that he was about to have a conversation which 40 years later would see him awarded the Nobel Prize in Economics.

But this life-changing conversation wasn’t with his dissertation adviser.

Sitting in the lounge that day was a sharebroker. The student and the sharebroker struck up a conversation and they soon began discussing the student’s ideas for his PhD. The sharebroker asked if the student could apply his ideas about statistics and linear programming to the problems of the share market. The student was intrigued and so was his dissertation adviser (when he eventually saw him). His thesis topic was beginning to develop, and the student was sent to meet with the dean of the business school to get more insight on shares.

The dean also found this to be an interesting idea and recommended the student read a book by John Burr Williams. At the time it was considered one of the best scholarly pieces on shares. Williams himself had been a sharebroker, but this was a challenging vocation during the Wall Street crash of 1929 and the subsequent economic depression. He enrolled at Harvard in 1932 to study what caused these events, and his eventual thesis was “The Theory of Investment Value.”

The name of our young student was Harry Markowitz. He read John Burr Williams’ paper and was struck almost immediately by the illogic of it. Williams began his paper by saying,

Taken to its logical conclusion, to follow Williams' advice would be to find the very best security at the very best price and put all your money into it. Most would think that’s foolhardy. Didn’t grandma say: “Don’t put all your eggs in one basket?”

Markowitz realised that investors don’t simply seek the best return. They also want that return to be as certain as possible. In his 1952 paper “Portfolio Selection”, Markowitz noted that portfolio selection is for investors who “consider expected return a desirable thing and variance of the return an undesirable thing.”

Markowitz never actually mentions the word “risk” in his paper. He simply says that variance of return is undesirable. With this single insight, Markowitz totally rejected Williams’ idea that a good investment is simply “the best at the price.”

Markowitz argued that the best investment was the one that gave investors the best expected return with the least amount of uncertainty.

But how can this be achieved? In his paper, Markowitz showed that by owning many different securities instead of just a few (an approach known as diversification), investors can achieve greater certainty of investment outcomes, without any reduction in expected return.

Peter Bernstein put it this way, “The mathematics of diversification helps to explain its attraction. While the return on a diversified portfolio will be equal to the average of the rate of return of its individual holdings, it’s volatility will be less than the average volatility of its individual holdings. This means diversification is a kind of free lunch at which you can combine a group of risky securities with high expected return into a relatively low risk portfolio.”¹

It shows the volatility and return of all components of the NZX 50 Index from May 2009 to April 2019 plotted on two axes. On the vertical axis is return. The higher the better. On the horizontal axis is volatility as a measure of uncertainty. The lower the better.

The orange dots represent the companies that make up the NZX50 Index. They look randomly scattered but the dot labelled NZX 50 is the combined market weighted return of all the orange dots. The NZX50 dot has two outstanding features:

• It has lower volatility than 98% of its component companies.
• It has higher returns than 74% of its component companies.

Now, you could play the John Burr Williams game of pick your favourite orange dot and hope. Or you could follow Harry Markowitz and simply buy a diversified portfolio of all the orange dots.

It could be that the anonymous sharebroker who met the young student Markowitz in the early 1950s gave him the greatest share “tip” of all time. It is simple to apply and easy to prove and provides investors greater certainty of achieving a better than average outcome. That’s one tip worth taking.

Think of diversification as your buddy. In these days of social isolation (maybe especially in these days of social isolation), we need all the buddies we can get.

Article by Ben Brinkerhoff

Ben is Head of Advice and has been with Consilium since the foundation of the business. Ben is responsible for Consilium Partner Services and business development, and sits on the Consilium Investment Committee.

Disclaimer: This article has been prepared for the purpose of providing general information, without taking into consideration any particular investors' objectives, financial situation, or needs. Any opinions contained in it are held by the author as at the report date and are subject to change without notice.

¹Peter L. Bernstein, "Against the Gods, The Remarkable Story of Risk".