The Magic Behind Modern Portfolio Theory

“Diversification is the only free lunch in investing.” -Harry Markowitz

Nobel Prize laureate Harry Markowitz coined the phrase, “diversification is the only free lunch in investing” based on his work with modern portfolio theory. Markowitz’s groundbreaking work demonstrated that, through diversification, investors could decrease portfolio risk without sacrificing returns or conversely increase returns without proportionately increasing risk.

Combining Offensive and Defensive Strategies

Markowitz concluded that maximum diversification benefits could be achieved when the correlation between investments is zero. A simplified approach: allocate 100% to an offensive strategy, such as long-only equities, and another 100% to a defensive strategy, such as trend following, in the same portfolio. As demonstrated below from actual index data, returns have been more than double yet volatility was only 33% higher than the average of each investment individually (not double) with this approach.

UNLOCKING THE MAGIC OF MODERN PORTFOLIO THEORY BY COMBINING OFFENSE AND DEFENSE IN ONE PORTFOLIO. GROWTH OF $10,000 (LOGARITHMIC SCALE).

Source: Catalyst Capital Advisors LLC and Bloomberg LP. Data from December 1999 to March 2024. Offense = S&P 500 TR Index. Defense = SG CTA Trend Index.

Statistic	Offense Only	Defense Only	Offense + Defense
Annualized Return	7.3%	6.0%	13.9%
Annualized Volatility	15.4%	13.5%	19.2%
Sharp Ratio (rf=0.25%)	0.46	0.42	0.71

A summary of the magic: more than double the expected returns, volatility only 33% higher than the average of both strategies, and almost double the risk-adjusted returns.

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