The great Harry Markowitz once told me that when he learned that James Tobin had won the Nobel Memorial Prize in Economic Sciences ahead of him, he took his wife out for an indulgent ice cream to try to get over the disappointment!
Of course, Markowitz was later awarded the same prize and is far more famous than Tobin. But Tobin’s contribution to the development of evidence-based investing, and optimal portfolio construction in particular, is arguably of similar importance.
Tobin’s Separation Theorem, which he outlined in a paper in 1958, wasn’t exactly rocket science. There should be two distinct parts to a portfolio, he said — one containing risky assets, the other risk-free assets (or as close to risk-free as possible).
To use a a soccer analogy, attackers attack and defenders defend. You want your equity funds to create and score goals; your safe and boring bond funds are there to keep them out.
Of course the active fund industry likes to think it knows better. It over-complicates things, and makes claims it can’t corroborate with evidence. First, it claims that active equity managers provide “downside protection” when markets fall (they generally don’t). Secondly, it claims that paying for an active bond manager will help you beat the market (after costs, they deliver consistent outperformance very rarely, and are only able to do so by taking risks — which rather defeats the object of using them in the first place).
As my latest post for Betafolio explains, sensible investors keep things simple — and the offensive and defensive elements of their portfolio completely separate.
Smart chap, James Tobin.
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