Steve Nash is the point guard for the Phoenix Suns of the NBA. Looking at some of his career statistics, in many ways they are pedestrian. Through the end of the 2006-07 season, he had averaged 14 points and less than three rebounds per game. Certainly there are those with far better statistics whom many would consider better players.

Kobe Bryant of the Los Angeles Lakers is one example. Yet, Steve Nash is a perennial All Star and two-time Most Valuable Player—an award that Bryant has never won.

Nash won such accolades because his contributions go beyond his individual statistics, especially points and rebounds. Nash's main contribution is that he makes everyone around him better players. This attribute is why Nash is generally considered the greatest point guard of his era. It also demonstrates why it is important to not view a player's value to the team by viewing his statistics in isolation. One needs to consider how the player impacts the team's overall performance.

The same thing applies to investing. A common mistake made by investors and even professional advisors is to view an asset class' returns and risk in isolation. Just as the only right way to consider the value of Steve Nash is to consider how his play impacts the entire team, the only right way to view an asset is to consider how its addition impacts the risk and return of the portfolio.

In 1990, Harry Markowitz was awarded the Nobel Prize in economics for his contributions to Modern Portfolio Theory. Markowitz demonstrated that one could add risky, but low-correlating, assets to a portfolio and increase returns without increasing risk (or, alternatively, reduce risk without reducing returns). The following example will demonstrate just how important it is to consider investments in the whole.

From 1991 through 2007, the S&P 500 Index returned 11.41% per annum and had a standard deviation of 17.0% per annum. During the same period, the S&P GSCI (Goldman Sachs Commodity Index) returned just 6.80% and had a standard deviation of 25.6%. Why would anyone consider including in a portfolio an asset class that experienced 4.61% per annum lower returns than the S&P 500 Index and also experienced much greater volatility? If you considered investments in isolation, that would not happen. However, a portfolio that consisted of 95% S&P 500 Index and 5% S&P GSCI would have provided a slightly higher return (11.42 versus 11.41) with a lower standard deviation (15.94 versus 17.0)—higher return, with less risk. This outcome was a result of the impact of the negative correlation (-0.20) of returns of the two asset classes. (We can define negative correlation as when one asset produces higher-than-average returns and the other tends to experience lower-than-average returns.) Every investor should prefer the portfolio that included the lower-returning and more volatile S&P GSCI.

As another example, consider the following. From 1970 through 2007, the MSCI EAFE (Europe, Australasia and the Far East) Index returned 11.57% per annum and had a standard deviation of 21.63%. During the same period, the S&P 500 Index returned 11.07%, with a standard deviation of 16.62%. Now consider a European investor: Should they have included the lower-returning S&P 500 Index as part of their portfolio? A portfolio that was allocated 50% to each of the two indexes would have returned 11.63%, higher than the return of either index. And, by including the lower-returning S&P 500 Index, the portfolio's standard deviation also fell from 21.63 to 17.07%. Once again, we see an example of higher returns with less risk.

From a U.S. investor's viewpoint, the combined S&P 500/EAFE portfolio also produced superior results. The portfolio with both asset classes increased returns from 11.07% per annum to 11.63% per annum (a relative increase of 5%). And while the standard deviation did rise from 16.62% per annum to 17.07% per annum, that is a relative increase of less than 3%. Thus, the combined portfolio produced superior risk-adjusted returns.

When considered in isolation, commodities appear to be a low-returning, risky asset. Yet, their inclusion has historically improved portfolio performance.

Summary

John Ruskin was an author, poet and artist best known for his work as an art and social critic. His essays on art and architecture were influential in the Victorian and Edwardian eras. He stated: "Not only is there but one way of doing things rightly, but there is only one way of seeing them, and that is seeing the whole of them."¹ Ruskin's advice applies to investing. There is only one right way to build a portfolio—by recognizing that the risk and return of any asset class by itself should be irrelevant, and that the only thing that should matter is considering how the addition of an asset class impacts the risk and return of the entire portfolio.

1 Richard M. Titmuss, Commitment to Welfare (George Allen and Unwin Ltd., 1976).

His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.