💾 Archived View for gmi.noulin.net › mobileNews › 4311.gmi captured on 2022-06-04 at 01:05:59. Gemini links have been rewritten to link to archived content
⬅️ Previous capture (2021-12-03)
-=-=-=-=-=-=-
January 07 2010| Filed Under Bonds, Financial Theory, Futures, Warren Buffett
If you were to craft the perfect investment, you would probably want its
attributes to include high returns coupled with low risk. The reality, of
course, is that this kind of investment is next to impossible to find. Not
surprisingly, people spend a lot of time developing methods and strategies that
come close to the "perfect investment". But none is as popular, or as
compelling, as modern portfolio theory (MPT). Here we look at the basic ideas
behind MPT, the pros and cons of the theory, and how MPT affects the management
of your portfolio.
The Theory
One of the most important and influential economic theories dealing with
finance and investment, MPT was developed by Harry Markowitz and published
under the title "Portfolio Selection" in the 1952 Journal of Finance. MPT says
that it is not enough to look at the expected risk and return of one particular
stock. By investing in more than one stock, an investor can reap the benefits
of diversification - chief among them, a reduction in the riskiness of the
portfolio. MPT quantifies the benefits of diversification, also known as not
putting all of your eggs in one basket.
For most investors, the risk they take when they buy a stock is that the return
will be lower than expected. In other words, it is the deviation from the
average return. Each stock has its own standard deviation from the mean, which
MPT calls "risk".
The risk in a portfolio of diverse individual stocks will be less than the risk
inherent in holding any one of the individual stocks (provided the risks of the
various stocks are not directly related). Consider a portfolio that holds two
risky stocks: one that pays off when it rains and another that pays off when it
doesn't rain. A portfolio that contains both assets will always pay off,
regardless of whether it rains or shines. Adding one risky asset to another can
reduce the overall risk of an all-weather portfolio.
In other words, Markowitz showed that investment is not just about picking
stocks, but about choosing the right combination of stocks among which to
distribute one's nest egg. (To learn more, see Introduction To Diversification
and The Importance Of Diversification.)
Two Kinds of Risk
Modern portfolio theory states that the risk for individual stock returns has
two components:
Systematic Risk - These are market risks that cannot be diversified away.
Interest rates, recessions and wars are examples of systematic risks.
Unsystematic Risk - Also known as "specific risk", this risk is specific to
individual stocks and can be diversified away as you increase the number of
stocks in your portfolio (see Figure 1). It represents the component of a
stock's return that is not correlated with general market moves.
For a well-diversified portfolio, the risk - or average deviation from the mean
- of each stock contributes little to portfolio risk. Instead, it is the
difference - or covariance - between individual stock's levels of risk that
determines overall portfolio risk. As a result, investors benefit from holding
diversified portfolios instead of individual stocks.
Figure 1
The Efficient Frontier
Now that we understand the benefits of diversification, the question of how to
identify the best level of diversification arises. Enter the efficient
frontier.
For every level of return, there is one portfolio that offers the lowest
possible risk, and for every level of risk, there is a portfolio that offers
the highest return. These combinations can be plotted on a graph, and the
resulting line is the efficient frontier. Figure 2 shows the efficient frontier
for just two stocks - a high risk/high return technology stock (Google) and a
low risk/low return consumer products stock (Coca Cola).
Figure 2
Any portfolio that lies on the upper part of the curve is efficient: it gives
the maximum expected return for a given level of risk. A rational investor will
only ever hold a portfolio that lies somewhere on the efficient frontier. The
maximum level of risk that the investor will take on determines the position of
the portfolio on the line.
Modern portfolio theory takes this idea even further. It suggests that
combining a stock portfolio that sits on the efficient frontier with a
risk-free asset, the purchase of which is funded by borrowing, can actually
increase returns beyond the efficient frontier. In other words, if you were to
borrow to acquire a risk-free stock, then the remaining stock portfolio could
have a riskier profile and, therefore, a higher return than you might otherwise
choose.
What MPT Means for You
Modern portfolio theory has had a marked impact on how investors perceive risk,
return and portfolio management. The theory demonstrates that portfolio
diversification can reduce investment risk. In fact, modern money managers
routinely follow its precepts.
That being said, MPT has some shortcomings in the real world. For starters, it
often requires investors to rethink notions of risk. Sometimes it demands that
the investor take on a perceived risky investment (futures, for example) in
order to reduce overall risk. That can be a tough sell to an investor not
familiar with the benefits of sophisticated portfolio management techniques.
Furthermore, MPT assumes that it is possible to select stocks whose individual
performance is independent of other investments in the portfolio. But market
historians have shown that there are no such instruments; in times of market
stress, seemingly independent investments do, in fact, act as though they are
related.
Likewise, it is logical to borrow to hold a risk-free asset and increase your
portfolio returns, but finding a truly risk-free asset is another matter.
Government-backed bonds are presumed to be risk free, but, in reality, they are
not. Securities such as gilts and U.S. Treasury bonds are free of default risk,
but expectations of higher inflation and interest rate changes can both affect
their value.
Then there is the question of the number of stocks required for
diversification. How many is enough? Mutual funds can contain dozens and dozens
of stocks. Investment guru William J. Bernstein says that even 100 stocks is
not enough to diversify away unsystematic risk. By contrast, Edwin J. Elton and
Martin J. Gruber, in their book "Modern Portfolio Theory And Investment
Analysis" (1981), conclude that you would come very close to achieving optimal
diversity after adding the twentieth stock.
Conclusion
The gist of MPT is that the market is hard to beat and that the people who beat
the market are those who take above-average risk. It is also implied that these
risk takers will get their comeuppance when markets turn down.
Then again, investors such as Warren Buffett remind us that portfolio theory is
just that - theory. At the end of the day, a portfolio's success rests on the
investor's skills and the time he or she devotes to it. Sometimes it is better
to pick a small number of out-of-favor investments and wait for the market to
turn in your favor than to rely on market averages alone.(To learn more, see
Warren Buffett: How He Does It and What Is Warren Buffett's Investing Style?)
by Ben McClure
Ben McClure is a long-time contributor to Investopedia.com.
Ben is the director of Bay of Thermi Limited, an independent research and
consulting firm that specializes in preparing early stage ventures for new
investment and the marketplace. He works with a wide range of clients in the
North America, Europe and Latin America. Ben was a highly-rated European
equities analyst at London-based Old Mutual Securities, and led new venture
development at a major technology commercialization consulting group in Canada.
He started his career as writer/analyst at the Economist Group. Mr. McClure
graduated from the University of Alberta's School of Business with an MBA.
Ben's hard and fast investing philosophy is that the herd is always wrong, but
heck, if it pays, there's nothing wrong with being a sheep.
He lives in Thessaloniki, Greece. You can learn more about Bay of Thermi
Limited at www.bayofthermi.com.