By Dan Danford, CFP

Do you bake? Have you ever tasted vanilla extract? Do you eat raw eggs? Though vanilla extract and raw eggs aren’t pleasing to the palate, they are ingredients for a world-class cake. When combined with flour, sugar, and other staples and heated in the oven, they turn into a mouthwatering bite of feathery goodness. Somehow, the combination is better than any of them on their own.

Portfolios are just like that. Some of the ingredients (stocks, bonds or mutual funds) might not be appealing on their own. Individually they might be too risky, too obscure or too concentrated for a direct holding. But as part of a diversified portfolio, they add an element that makes for solid long-term performance.

We hear good questions all the time:

“Why keep so much money in bonds when they are paying such a low rate?”

“I just watched Cramer on CNBC and he said small companies are going to underperform this year. Why don’t we get rid of them?”

Most of the time our answer is this: “They are part of your portfolio because the combined ingredients are better than any of them would be individually.”

Considering the Portfolio as a Whole

Up until the 1950s, most investment research focused on individual stocks and bonds. Which is the best stock, Ford or General Motors? How do you decide between several corporate bonds? What methods of choosing predict the best purchase for a portfolio?

In 1952, the Journal of Finance published Harry Markowitz’s pivotal paper, “Portfolio Selection.” Over the next 40 years, considerable academic research studied portfolio behavior.

In 1990, three people—Markowitz, Merton Miller and William Sharpe—earned the Nobel Prize in Economics for their portfolio studies. That body of knowledge came to be known as modern portfolio theory. It’s tested and true, and stands as genuine investment science today. Like any science, the total body of knowledge continues to grow over time.

Risk and Reward in Investing

The key concepts regard diversification. Diversification wasn’t a new idea in investing. But some diversification findings rocked the investment world. First, it’s important to remember that risk and reward are completely and totally related. That’s the one absolute economic truth. It’s always been understood that riskier investments reward investors with higher returns. That’s why, over the long haul, stocks tend to outperform bonds. Higher performance is pay for taking higher risks. (For related reading, see: Risk and Diversification: The Risk-Reward Tradeoff.)

[Note: In investment research, portfolio fluctuation is used as the primary measure of risk. Dramatic portfolio fluctuations are more likely to produce a negative outcome.]

What wasn’t widely known before modern portfolio theory is mixing and matching investments can positively alter a portfolio’s risk/reward profile. In fact, the most stunning finding was that mixing certain types of investments can lower portfolio risk while increasing portfolio returns.

Let that sink in.

A common truth is that all investors seek high returns with low risk. It’s part of human nature. Most of us are born with extreme risk aversion: “I want something that pays high returns without any risk.”

Now, after 60+ years of academic testing, we discover (they discovered, we just follow their work) the right mix of investments can reduce portfolio fluctuations without hurting returns. Or, at least returns aren’t reduced to the degree you might expect.

An Illustration of the Benefits of Diversification

Think about two stacks of paper. One holds $10,000 worth of stocks, the other $10,000 worth of Treasury bonds. The expected 10-year return from these stacks is quite different and somewhat predictable. Without quibbling over details, let’s agree that the stock stack should grow at an estimated 10% rate annually, the bond stack at 5%.

For sake of example, let’s assign a simple risk number to each. Let’s pretend that our scale rates the stocks with a risk of two and the bonds with a risk of one.

Now, if we mix the two stacks to form a portfolio, we’d think the expected annual return would be 7.5%, halfway between the two. Our expected risk should be 1.5, again halfway between the two.

What the research discovered, however, is the returns are above 7.5% and risk is below 1.5. Stocks and bonds meld together to increase returns while lowering risks. Clearly, the combined portfolio is better than the sum of the parts. This was a revolutionary investment idea. (For related reading, see: The Importance of Diversification.)

Negative Correlation in a Portfolio

Further, this magic works with any dissimilar assets. Mathematically, dissimilar assets are any investments with negative coefficients of correlation. The simple way to explain this is one zigs while the other zags. So you can increase portfolio returns and reduce risks by matching real estate with stocks. Or bonds. Or precious metals. The more diverse a portfolio, the more dramatic the improvement.

Though this improvement is counterintuitive, it’s been proven again and again. You can improve a conservative portfolio (raise returns and reduce fluctuations) by adding some riskier holdings.

According to modern portfolio theory, a portfolio mix of 85% bonds and 15% stocks is safer and more productive than a portfolio of 100% bonds. Before modern portfolio theory, no one would have believed this. Some people still have trouble believing it. (For related reading, see: Modern Portfolio Theory: Why It’s Still Hip.)

There’s at least one important disclaimer to this. Though the science is real, it’s somewhat inexact. It’s a bedrock concept for long-term investing. It doesn’t have predictive power; in fact, it argues against trying to predict the future. Rather, it suggests that a properly constructed portfolio will perform better with less risk over a wide variety of market cycles.

It’s a bit like predicting the weather. The science is helpful over time, but it fails to be accurate with all forecasts all the time. Modern portfolio theory doesn’t even try to forecast the future. Diversified investors are rewarded with higher returns and lower risks across many market environments. There will be rough spots, but relatively, takings both risks and rewards into account, a modern portfolio should outperform others.

(For more from this author, see: Determining a Financial Advisor’s Value to You.)

This article was originally published on Investopedia.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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