Volatility and risk are different things

Modern portfolio theory (MPT) assumes the equivalence of price volatility and risk and posits that the ultimate objective of portfolio construction is to optimize this definition of risk. This is the so-called “efficient frontier” that maximizes return for any level of volatility or, conversely, minimizes volatility for any desired level of return. It is an elegant construct – so elegant that it earned Harry Markowitz the Nobel Memorial Prize in Economics in 1990. However, to loosely quote another famous U.S. economist, Yogi Berra:¹ “In theory, practice and theory are the same thing, whereas in practice, they are not.”

In the practical world, investors love upside volatility: Rising markets make everyone look smart and feel wealthier. It’s the downside we seek to avoid. MPT is helpful, but most investors define practical risk in more absolute terms – the possibility that they might lose their money and not get it back. Risk is, in other words, the prospect of a permanent loss of capital.

In fact, price volatility somewhat counterintuitively turns out to be a long-term investor’s best friend. There are two reasons for this. First, whereas financial markets are efficient over time, they are not efficient all the time. All active investment strategies essentially distill down to the effort to exploit the differences that arise between price and value. If an investor can acquire a dollar’s worth of value for (say) 70 cents, then they are likely to earn a decent return as price and value converge over time. This is easier said than done: It requires time-consuming, robust analysis to determine the intrinsic value of a security, and then patience to allow the market to recognize the value inherent in the investment.

Second, reversion to the mean is one of the most powerful forces in financial markets. Using public equities as an example, bouts of price volatility are often followed by outsized returns. Consider the nearby table, which explores the return of the S&P 500 large-cap index following periods in which the CBOE Volatility Index (VIX) spikes above 35. These outsized surges in volatility have happened only 16 times in the past 35 years, and the S&P index was higher in 13 of those 16 historical periods – on average, by almost 16%.

To be clear, price volatility is not pleasant. Jarring headlines and sharp drops in prices are disconcerting when they take place. Yet they do not pose a risk to long-term patient investment approaches.

Inflation is an investor’s worst enemy

But there are real risks beyond the perceived disruption of price volatility. Some of these risks are episodical, cyclical, and unpredictable: Business cycles come and go, geopolitical unrest can send markets in unpredictable directions, and extraordinary popular delusions and the madness of crowds² can send asset prices up and down without any readily identifiable external causes. Inflation, on the other hand, rarely rises to the level of breathless headlines, but lurks insidiously in the background of every portfolio, sapping purchasing power a little at a time throughout the lifetime of an investor.

Inflation is therefore the quietly persistent worst enemy of an investor, although not so quiet as of late. Pent-up demand and supply chain constraints sent inflation soaring in the waning days of the COVID-19 pandemic (to a peak of 9.1% in June 2022), with a more recent and modest surge fueled by hostilities in the Middle East. It is quaintly charming to recall that in the period of quiescent inflation between the global financial crisis (GFC) and the pandemic (in which inflation averaged 1.6%), the prevailing concern was the absence of inflation and how central banks might counteract the possibility of deflation.

But inflation need not grab headlines to pose a risk over the long run. Most investors are familiar with the miracle of compound interest – how a small amount of money can turn into a large fortune over time, even at a low interest rate. Inflation is its evil twin, as it can sap the purchasing power of wealth, even at an unremarkable rate of inflation. Consider the nearby graph, illustrating the decline in purchasing power over a 25-year period at various rates of interest. At the modest level of 2%, $100 loses 40% of its real value over 25 years. At 4%, the loss climbs to 64%, and at higher levels of inflation the damage to real wealth is even more sobering.

Economies expand and contract, political uncertainty waxes and wanes, market sentiment swings from ecstasy to abject despair. Inflation persists.

Asset classes play discrete roles in a portfolio

How does an investor protect a portfolio against this omnipresent risk of inflation? This question introduces the importance of explicitly identifying the role that each asset class plays in a portfolio and proactively adjusting allocations over time as market conditions, return requirements, and risk tolerances evolve.

Portfolio construction is ultimately an exercise in asset liability matching. People, like companies, have assets and liabilities, and, like companies, those assets and liabilities may be tangible or intangible. For an individual investor, intangible liabilities might include the importance of protecting against inflation, the need for liquidity, the desire to grow assets, the appeal of tax efficiency, and so forth. These “liabilities” vary from investor to investor, and even vary for the same investor as circumstances change over time. So, too, will the right asset allocation. Hence the necessity of regular review and revision, when appropriate.

Equities have provided the most reliable protection against inflation over time, particularly the equity of companies with strong balance sheets, prodigious free cash flow, pricing power, and loyal customers. These attributes allow companies to pass on cost increases to their end customers, providing inflation protection to their shareholders. The deeper allocations between public and private markets, larger or smaller companies, and domestic and international stocks introduce more refined levels of decision points, allowing an investor to accept more or less liquidity, currency diversification, and capitalization breadth, among other things.

Conversely, equities are not the best solution for meeting liquidity needs. Yes, public equities can be sold on short notice and for quick settlement, but it might not be desirable to sell public equities in (for example) a bear market. Fixed income is better suited to play the role of meeting liquidity needs, particularly in short-duration and higher-quality assets. Fixed income furthermore acts to dampen portfolio volatility for those investors who want to mitigate the disruption of price volatility.

We find that private assets are playing an increasingly important role for investors who can afford to part with liquidity for some of their portfolio. Liquidity is a good thing: Ready access to your money is a benefit, and giving up that benefit ought to be rewarded with returns above those on offer in public markets. Contra our Berra quote earlier, we find that theory and practice align on this point and that private assets should and do provide incremental returns to portfolios over and above public equivalents.

Private markets are playing a larger role in portfolio construction

The biggest shift in market structures over the past generation is the steady expansion of private markets (both equity and debt) and the concurrent decline in the importance of public markets. This is an admittedly subjective observation, but one that can be backed with a few objective facts.

There are 30 million companies in the U.S., of which only about 4,000 are traded on a stock exchange. This figure of 30 million admittedly includes many single proprietor or “mom and pop” shops. If we exclude these smaller companies, the landscape becomes even starker. Of all the companies in the U.S. with over $100 million of revenue, 87% are privately owned.³ The business of the U.S. is private business. Investors who limit themselves to public markets are therefore accessing only 13% of the available investment opportunities.

This is not a new development. For most of the modern history of U.S. financial markets, companies sought to go public as soon as possible in order to access the capital on offer in public markets. As the nearby graph illustrates, initial public offerings (IPOs) and listings pushed the number of publicly traded companies higher through the 1980s and into the 1990s, to a peak of 8,090 in 1996. From there, however, and coincident with the acceleration in private equity (as well as an increase in the financial reporting requirements of public companies), the number of listed companies has declined to a low of 3,908 as of the end of 2025.⁴ There are half as many public companies now as there were three decades ago.

Deeper private markets enable companies to remain private for longer (or even forever), as they can finance growth without relying on public markets. A key implication for investors is that growth in company values increasingly takes place in the private markets. When companies do go public, they do so at higher and higher initial valuations. We are confident that SpaceX won’t be the last company to go public with a trillion-dollar capitalization.

Private debt markets have witnessed a similar evolution. As bank lending regulations tightened up following the GFC,⁵ markets, like nature, abhor a vacuum, and private capital stepped up where traditional bank lending stepped back. Private debt, however, is increasingly broadening out beyond a reliance on private equity into asset-based finance, infrastructure, lending, and non-sponsored lending, which should increasingly provide better diversification.

Private investments are not for every investor. These asset classes introduce illiquidity and added tax complexity into a portfolio. Nevertheless, we believe that these added costs are more than adequately compensated by the prospect of incremental return.

Appropriate diversification is essential to long-term success

This final tenet is a combination and culmination of some of the beliefs outlined earlier. Market opportunities have broadened beyond an old-fashioned approach in which a portfolio composed of (for example) 60% large-cap stocks and 40% municipal bonds sufficed. The fragmentation of equity and fixed income creates opportunities, as does the development of new asset classes that are less correlated with traditional investments. A broader opportunity set allows for portfolio construction that more effectively balances an investor’s needs with available investment options.

The concentration of public markets provides another case for intentional diversification. The 10 largest stocks in the S&P 500 account for 38% of the value of the whole index,⁶ and all but one (Eli Lilly) are squarely in the AI space. This level of sector concentration is not unprecedented. There have been cycles in the past in which energy or financials have dominated the index. This concentration may, however, become more common in the future due to the dynamic discussed earlier of companies going public at larger valuations. If, for example, SpaceX were to be followed by the IPOs of other large AI-driven companies, the concentration of the index could become even more acute. Passive investing, particularly when executed in a tax-efficient manner, makes sense for many investors, as equities play an important role in portfolios (see earlier). This index concentration, however, argues for complementing a passive approach with active equity strategies (particularly in less efficient asset classes) to introduce more appropriate equity diversification than the index itself offers.

Finally, we recall again the framing with which we opened these comments. The future has always been unpredictable, but it now seems more unpredictable than before. The range of possible economic, geopolitical, and technological outcomes has broadened. In our pursuit of preserving and growing the wealth of our clients, we prefer to diversify our positioning across a range of market scenarios and client needs rather than stake portfolios to one particular outcome. Diversity breeds resilience.

Conclusion

We believe that investing is a marathon, not a sprint. Where the application of these precepts may not work every time, we believe that they work over time. In fact, we believe that the investment philosophy entailed within these principles is the best way to invest in pursuit of the long-term preservation and growth of capital.

These tenets are by no means widely shared throughout the wealth management industry and are far easier to put into print than to put into practice. Although not explicitly stated in the preceding passages, contrarian thinking and contrarian action are necessary corollaries to each of these ideas, and that is not easy in an industry dominated by herd mentality and overwhelmed by the flow of information.

It is, however, somewhat easier in a privately owned and privately managed firm that is free from the distraction of public ownership, which allows for a genuine long-term investment perspective and a client base that aligns with these perspectives. This is what guides us as we manage client portfolios, whether through asset allocation, portfolio construction, manager selection, or risk management.

Recent years have taught us that certainty is expensive and humility is underpriced. We believe the appropriate response to these lessons is neither to retreat into indecision nor to double down on any single view of the future, but to combine durable convictions with a willingness to update them. Conviction without flexibility becomes dogma; flexibility without conviction becomes drift. Our commitment is to hold both – to know what we believe and why, to test those beliefs continually against changing conditions, and to have the discipline to act when the world tells us something new.