Lots of people have had lots of theories about how to make money by investing in stocks. Long-term investing is one approach. A few try to time the market, with the tricky part knowing when to get out. Some think luck can be just as successful as clever analytical techniques, a theory made famous by Princeton professor Burton Malkiel, whose book, “A Random Walk Down Wall Street” (now in its 11th printing), maintains that one cannot consistently outperform market averages.
But for lots of people technical analysis has been critical. One widely quoted theory is that of economist Harry Markowitz, who in a 1952 paper argued that prudent investors should have diversified portfolios, with careful attention paid to the market risk and return of each class of asset.
Now the Markowitz approach is being fine-tuned by another former member of the Princeton academic community. Ashvin Chhabra, chief investment officer and head of investment management and guidance at Merrill Lynch Wealth Management, has made his mark with a 2005 paper titled “Beyond Markowitz” published in the Journal of Wealth Management. Chhabra will address the Princeton Camber of Commerce membership luncheon Thursday, January 8, from 11:30 a.m. to 1:30 p.m. at the Princeton Marriott, 100 College Road West. He will discuss investment strategies as well as his outlook for 2015. For information visit www.princetonchamber.org.
Chhabra grew up in New Delhi, where his father owned a large newspaper and his mother was a well-known journalist who later took an interest in public affairs and served as India’s deputy minister of health.
Chhabra earned his undergraduate degree in physics at St. Stephen’s College in New Delhi, India, in 1982. After earning a master’s at the University of Georgia, he did his Ph.D. in applied physics at Yale.
Early in his career Chhabra was head of quantitative research at J.P. Morgan Private Bank. He joined Merrill Lynch in 2001 and gained recognition as a leader in the fields of investment management, risk and asset allocation, and risk management.
Chhabra directed wealth strategies and analytics at Merrill Lynch from 2001 through early 2007 at Merrill Lynch before it was absorbed by Bank of America. At that time he left the brokerage company to manage endowment funds at the Institute for Advanced Study in Princeton — hometown for him and his wife, Daniela Bonafede-Chhabra and two children. (Daniele is a trustee of Princeton Community Housing.) When his return to Merrill Lynch was announced in 2013 at an investment training program in Phoenix, the audience of about 500 financial advisers reportedly broke into “spontaneous applause.” As Andy Sieg, head of global wealth and retirement solutions at Merrill, was quoted as saying, “They feel like an old friend is back.”
In his “Beyond Markowitz” paper, written while he was originally with Merrill Lynch and published by the Journal of Wealth Management, Chhabra argues that, while stockbrokers have placed a “renewed emphasis on educating investors about the benefits of portfolio diversification,” more than a half century after Markowitz’s paper most individual investors are not diversified.
Rather than dismissing these investors as “irrational,” Chhabra notes that some people have become rich by ignoring the traditional “diversity” model of investment and sought to understand the underlying reasons for investor behavior. The result of his investigation was a synthesis that introduced to the investing world the concept of goal-oriented investing: That each investor’s portfolio should take into account not only market factors and risk tolerance, as the Markowitz paper argued, but also the individual’s desired level of security and aspirations for growing wealth.
Chhabra argues that for most investors, portfolios should be divided into two distinct categories. The first should be a safe “personal” risk category designed to preserve assets and lifestyle no matter the market conditions. These investments accept low returns in exchange for increased security. Personal investments include things like primary residences, bonds, education (which pays off in career earning power), insurance, and a cash reserve for emergencies.
The second category of investments should be a “market” risk portfolio composed of equities, index funds, and other such investments that will rise and fall along with the market. (There is a third category for super rich investors called “aspirational” risk.)
The advantage of having two separate asset allocations is that market assets are volatile — subject to wild swings in value — but tend to yield good returns over a long period of time. When all of a person’s assets are in market investments, their psychology and immediate needs force them to make counterproductive decisions.
“Individuals’ portfolios just do badly,” Chhabra said in a phone interview. “When the market is going down, they start to sell because they think of the safety of their portfolio, and they get out. When the market is going up, they forget about safety, and put everything in the marketplace.” The result is buying high, selling low.
By having two risk classes, investors are able to keep their investments in the market through its wild swings and reap the benefits of long-term investing while knowing their low-risk assets are still secure. Chhabra notes that getting good returns from the market is ever more important for people because fixed-benefit pension plans have been replaced by fixed-contribution investments.
“We have tried to understand the reasons for the lack of diversification and emphasized that the risk-return preferences of individual investors are different from those of the markets,” Chhabra wrote in his landmark paper. “To address this, we have built upon Markowitz’s work to provide a wealth allocation framework that is suitable for individual investors. This expansion starts with incorporating all of an investor’s assets and liabilities including home, mortgage, and human capital, as opposed to just financial assets. We introduced the concepts of personal risk and aspirational risk to supplement the market risk framework of Markowitz.
“This allows us to add the ability to provide downside protection and upside potential to the usual diversified core portfolio, based on an individual investor’s risk and return preferences. The goal of this wealth allocation framework is to allow for the optimum allocation of risk, i.e., budgeting of one’s resources, among the personal, market, and aspirational risk dimensions, to simultaneously meet the investor’s safety and aspirational goals while still benefiting from efficient markets. In order to achieve an appropriate allocation of wealth for the individual investor, risk allocation must precede asset allocation.”
The paper has proven influential in the finance world and increased in popularity after the financial crash of 2008. Chhabra’s advice was controversial in 2006 because he thought of a home as a low-performing investment.
“My advice was to buy a modest home that can survive through any crisis, and in effect, pay off your mortgage over time,” he said. “We were advising the opposite of what everybody was telling you to do at that point, which was to buy a big house because you get leverage on that investment, and you get tax benefits on the mortgage, and houses were going up 30 percent a year.”