About Us: Philosophy

Prudent Process

Ely Prudent Portfolios, LLC manages investment decisions according to a structured process based on modern prudent fiduciary practices.

Risk / Return Tradeoff

Our central consideration when investing and managing the assets of our clients is to determine the tradeoff between portfolio risk and return. The concept of determining tradeoffs between portfolio risk and return began in 1952 with the Publication of Portfolio Selection by Harry Markowitz. At that time investment theory only focused on maximizing return without considering risk. Therefore diversification was equivalent to holding a large number of stocks based solely on the expected return of each stock. But Markowitz realized that diversification depends more on how securities relate to each other than just on the number of securities in the portfolio. Because the prevailing theory of diversification did not account for risk, Markowitz thought it was quite naïve and potentially very risky. 

Markowitz’s identification of the risk/reward relationship was revolutionary and yet, many investors do not implement this very simple idea. For example, investors following the “naïve” approach to diversification in 1999 might have concentrated many Nasdaq stocks in their portfolio, only to see them collapse the following year. By focusing only on return without taking risk into consideration, Markowitz believes and mathematically proves they are investing in an “inefficient” way.

Variance Drain

Markowitz realized what distinguishes an efficient portfolio from an inefficient one is the degree to which the individual parts of the portfolio are correlated.  It is the strength and direction of the relationship between the returns of different securities, not merely the number of securities held that provides the risk-reducing benefits of diversification.  Markowitz’s basic assumption was that risk is measured by variance. Variance is a measure of portfolio volatility (the average deviation from the mean.)  Variance drain is the mathematical explanation why two portfolios with same average return but different variances will have different compounded rates of return.  The one with the greater variance will have a lower compounded rate of return.  Therefore, an efficiently diversified portfolio, the one with the smaller variance, has a higher probability of producing wealth over time, even though in any given time period the inefficiently diversified portfolio may have a higher expected return.

The following example shows how variance drain can, unexpectedly, penalize those that attempt to maximize portfolio return: 

Assume that a portfolio starts with $100 and makes 50% in year one and loses 50% in year two.  At the end of the first year the portfolio value is worth $150 ($100 x 1.5), but drops to $75 ($150 x 0.5) by the end of the second year.  The portfolio made 50% and the next year lost 50%.  The average return was 0%, but the portfolio dropped in value by 25%.  If the annually volatility was half as much, up 25% and down 25%, the portfolio would grow to $125 in year 1 ($100 x 1.25) and drop to $$93.75 in year 2 ($125 x 0.75), the loss would be only 6 ¼%, not 12 ½%.

The lesson to learn from this example is that losses have a bigger impact on a portfolio than gains and big losses have a significantly larger impact than big gains.

Conclusion

Because of variance drain, constructing portfolios by selecting securities with the highest expected returns, instead of low correlation of returns, reduces the long term expected return, even though in the short term the expected return may be higher. Therefore, it is an interesting phenomenon that advisors who attempt to maximize returns may actually be decreasing the probability of long term success for their clients.