Another of his contributions was to elevate the concept of ‘relative returns’. Before Markowitz, people used to judge performance on whether a portfolio made or lost money. Come Markowitz, the relative test became how securities performed against a benchmark such as the S&P/ASX 200 Index.  

Nowadays, the Markowitz concepts of diversification, asset allocation and relative returns and the Micawber advice on income covering spending are everyday investment concepts. So too are terms such as defensive and growth assets, investment goals and risk appetite. Others are compound interest, price-earnings ratios, dividend yields, even capital-gains tax.

How to define?

What’s a novice investor to make of the terms that plague investing? The most constructive approach might be to attain a rudimentary level of financial literacy. The good news is that it won’t necessarily take that much effort and time to learn the basics. The government and the finance industry including the ASX are trying to make it as easy as possible.

What does it mean to be financially literate? The term can be defined as the ability to make informed decisions about money to help meet financial goals. In practice, this means people need to organise their finances to ensure they can pay for their daily needs. They then should seek to understand how to invest their super and other savings. It doesn’t mean that people need to become experts on company balance sheets, earnings reports, economic theory, trading strategies and valuation techniques, and so on.

Managing super and other savings, however, demands a higher level of financial literacy. To navigate the investment world, people might want to understand concepts such as economic growth, inflation and interest rates. It’s helpful to comprehend how the different asset classes are structured. An equity, for instance, in a tradeable share in the ownership of a company that gives the owner the right to share in the profits of a company. The price of this stake is theoretically based on the worth today of that company’s future profits. A bond can be considered a tradeable loan where the prevailing yield indicates the market value of the loan, which usually offers regular interest payments and is fully repayable.

Financial literacy extends to understanding the risk-and-return profile of each asset class. The fact that bond holders get their money back if they hold these securities to maturity means bonds are less risky than shares. Equities, of course, can even become worthless if a company’s fortunes slump. History shows, however, that share markets may offer better returns over the long term compared to the returns for bonds, although this is dependent on the relevant equity and prevailing economic conditions. Some equities have tended to recover from sudden declines, though, there is no guarantee of this result. 

People might want to understand how the state of the economy influences the returns on asset classes. Inflation, for example, introduces the concept of real, or inflation-adjusted, returns, which affect the performance of the asset classes in different ways. Cash returns often fail to keep up with inflation. Inflation erodes bond prices (yields rise) because the real value of future bond payments declines. 

The Markowitz mark

It's helpful too to understand the rudiments of portfolio theory. The Markowitz concept that diversifying across asset classes lowers portfolio risk is now a principle of investing – so too is holding a diverse portfolio of stocks rather than just, say, one name. Time has shown the major asset classes of bonds, cash and stocks perform differently across economic conditions. The right mix may steady returns.

Being financially literate can apply at a personal level too. People are advised to consider their investments as a whole – as one portfolio – to ensure proper diversification. They should be able to define their investment goals. Are they saving for a short-term goal such as buying a car? Or do they have a long-term goal because they are saving for retirement?

Another form of financial literacy is understanding the psychology behind investing. Studies show that people are often hurt by losses more than they enjoy gains. The trap for investors here is that short-term ‘noise’ can prompt people to sell in falling markets, rather than take a long-term view. Some may hold the view that selling when prices are falling could result in missing out on a rebound in prices. Google: ‘Time in the market rather than timing the market’ to find examples of how some of the best-performing days on share markets occur after a big drop.