A toast to James Tobin, the forgotten Nobel laureate
The intellectual argument between evidence-based investing and big fund management companies is an embarrassingly uneven contest. They have their in-house “research” teams (often closely connected to the marketing department), while we, on our side, have some of the greatest minds in academic finance.
Paul Samuelson, Harry Markowitz, William Sharpe, Eugene Fama… How many Nobel Prize-winning economists do you need to convince you that paying for active management is a bad idea?
But although it’s those four who tend to receive the most attention, there is a fifth Nobel laureate who has made a significant contribution to the development of evidence-based investing. His name is James Tobin.
It was Markowitz (1), who died in June at the age of 95, who laid the foundations for what became known as Modern Portfolio Theory in his 1952 paper Portfolio Selection (2). Markowitz found that, when combined together, asset classes whose returns are “imperfectly correlated” can help to make for a smoother investment journey without giving up returns.
For Markowitz, deciding what to invest in is as much about managing risk as managing returns. What a rational investor should seek to own is an efficiently diversified portfolio.
The market portfolio
But what does an efficiently diversified portfolio look like? James Tobin addressed that question in a paper published six years later, in 1958. (3) 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 (effectively a giant index fund, although the concept had not yet been invented).
In an ideal world, 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 low-risk assets such as high-quality, short-duration bonds can be considered a reasonable substitute.
This idea of dividing the portfolio between risky and risk-free assets 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 Economic Sciences in 1981 — nine years before Markowitz was awarded his.
Whisky and water
In his excellent book, Smarter Investing, Tim Hale uses a brilliant analogy to explain Separation Theorem. Apparently, it was one of Tim’s clients who coined the phrase the “whisky and water” approach.
“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 great way of looking at the growth component of an evidence-based portfolio. This, if you like, is the portfolio’s engine — it drives returns. It should either comprise 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 perfect way to illustrate the defensive part of a portfolio. For this, most evidence-based advisers use short-term government bonds.
Even if you think you can stomach a few neat whiskies, you may come to regret it in the morning. And it’s just the same with stocks. They might feel pleasantly intoxicating now, after a surprisingly positive year so far for global equities, but there may come a time, perhaps sooner than you think, when you wish you hadn’t over-indulged.
And, on that cautionary note, we should raise a glass to the late James Tobin — watered down, of course.
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Robin Powell is a journalist, author and editor of The Evidence-Based Investor.