The two components every portfolio needs
When looking for evidence on how to invest, I think we can all agree that Nobel Prize-winning research is not a bad place to start.
Paul Samuelson, Harry Markowitz, William Sharpe, Eugene Fama and Daniel Kahneman are all recipients of the Nobel Memorial Prize in Economic Sciences. And they’ve all contributed greatly to our understanding of what successful investing entails.
There is, however, another Nobel laureate who barely gets a mention. His name was James Tobin, and his research underpins one of the central principles of what is now called evidence-based investing.
A pioneer in portfolio construction
A Harvard-trained economist, Tobin is best known for the work he did at Yale in the 1950s. His principal interest was in portfolio construction, an expertise he famously shared with Harry Markowitz.
Strange as it may seem today, how to build a portfolio was then a very under-researched subject. Up to that point, academic finance had focused on the performance of individual securities and asset classes, not the investment portfolio as a whole. Tobin and Markowitz were genuine pioneers.
In a paper published in 1952, Markowitz laid the foundations for what became known as Modern Portfolio Theory. His main conclusion was that, when combined together, asset classes whose returns are ‘imperfectly correlated’ can help to make for a smoother investment journey without giving up return.
For Markowitz, deciding what to invest in is as much about managing risk as managing returns. What a rational investor should seek to own, he explained, is an efficiently diversified portfolio.
Tobin’s Separation Theorem
Tobin built on that work and indeed took it a stage further. In a paper published in 1958, he asked the question: What does an efficiently diversified portfolio actually look like?
The most efficient portfolio available, Tobin argued, is the ‘market portfolio’ – that is, all the equities and all the bonds in the world, weighted by market capitalisation.
By that he effectively meant a giant index fund, although the concept had not yet been invented.
Ideally, Tobin argued, investors should own this market portfolio, but then add risk-free assets to reduce their overall risk exposure. Of course, no asset is entirely free of risk, but cash, for example, or, better still, high-quality, short-duration government bonds are sensible substitutes.
This idea of dividing the portfolio between risky and risk-free assets – or, if you prefer, a growth element and a defensive element – came to be known as Tobin’s Separation Theorem. It was principally for that and other work in relation to MPT that Tobin was awarded the Nobel Prize in 1981, nine years before Markowitz was awarded his.
Whisky and water
In his book Smarter Investing, Tim Hale uses an excellent analogy to explain Separation Theorem – the ‘whisky and water’ approach to portfolio construction.
“Considerable care is taken in the creation of a blended malt whisky,” Tim writes, “to create a distinctive flavour from a number of single malts that is robust and will remain consistent over time.”
That’s a good way of looking at the growth component an evidence-based portfolio. This growth element is, if you like, the portfolio’s engine – it drives returns. It should either consist of globally diversified, cap-weighted index funds or funds designed to capture specific risk premiums, such as size and value, or - best of all - a combination of the two.
Whilst some will drink their Scotch neat,” Tim goes on, “others, depending on their palate and their desire to avoid ill effects, will dilute it with water to a flavour and strength that is right for them.
Again, this is a brilliant way of explaining the defensive part of a portfolio. For this element, most evidence-based advisers use short-term government bonds.
Tobin’s relevance today
So what, if anything, can James Tobin teach investors and financial advisers today? Well, it’s certainly true that Tobin is less well known than Harry Markowitz, but his work has clearly stood the test of time.
Most portfolios tend to be very messy, with no clear distinction between risky and risk-free assets. For many in the asset management industry, actively managed bond funds are just another way of trying to maximise returns. But, as with active equity funds, the vast majority fail to outperform the index after costs in the long term.
Of course, there are bond fund managers whose short-term outperformance attracts attention. Ten years ago, for example, Michael Hasenstab was tipped as the next Bill Gross (the most famous bond manager of all).
Hasenstab made his name by betting big, and when things were going well for him, assets flooded in. But over the years his performance dived. In 2019 he lost $1.8bn in a single day on a bad bet on Argentina. He made another disastrous call last year when he bet that bond prices would fall. Now assets are flooding out.
Keeping it simple
For investors today, as in Tobin’s day, the logical approach is to keep it simple.
First, decide how much risk you need to take, can afford to take, and feel comfortable taking. Then, allocate an appropriate proportion of your portfolio to equities.
With the rest, don’t try to be clever. Simply invest in a passively managed and globally diversified government bond fund or funds, not an active manager like Hasenstab who would put your capital at risk.
Don’t expect your bonds to deliver an impressive return. That’s not what they’re for. See them instead as simply watering down the risk you’re taking.
Remember, markets can be very scary. Just think back to March last year – the steepest bear market in living memory. Since then, owning stocks has felt pleasantly intoxicating, as global markets defied expectations and rose to new heights.
But things can change again very quickly. There may come a time, perhaps sooner than you think, when you wish you’d mixed a little more water with your whisky.
1 Markowitz, H. M. (1991) Portfolio Selection: Efficient Diversification of Investments 2nd Edition, Cambridge, Massachusetts: Basil Blackwell
 Tobin, J. (1958) Liquidity preference as behaviour towards risk, The Review of Economic Studies, 67