Risk, correlation, and modern portfolio theory
Reader comments sometimes state that Moneywise articles are not as detailed as they should be. Just a gentle reminder that The Royal Gazette personal finance column space size is limited each week, necessitating more general topical information to incent you the reader to research further.
The Bermuda Fundamental Financial Planning Primer Series, a culmination of 20 years of financial columns, is scheduled for publication in seven phases over the next two years and will provide far more in-depth relevant features.
Any individual or entity who has investments in capital markets is exposed to two things: opportunity for gains and/or income, and risk of reduction in or loss of capital. Everyone can include all Bermuda private company employees and employers who have savings invested in the Bermuda National Pension Scheme.
Further, security valuations (prices) tend to fluctuate in value, some securities far more than others, during any trading period due to many internal and external influences. This back and forth in security price variation is typical for any trading exchange; buyers buy and sellers sell, achieving between them an equilibrium price for the transaction.
However, while typical, not all investors are comfortable with such activity. They, or their portfolio or various mutual funds’ managers, will want to “hedge their bets” by putting in place strategies to smooth investor owner’s return on investment. Such savings investments are held at various local insurance and investment firms who have either on staff, or on contract, qualified licensed professional portfolio managers to make these important and necessary investment decisions.
Individual investment feedback from meetings, seminars, and columns over the years have ranged the gamut, highlighting why many small investors may have tried to self-manage, but no longer participate on an individual basis in investment markets. Examples:
• “When I look at my investments, I just hate seeing any losses, so I get rid of all the losers, and buy only those winners with great increases in value.” Buying high and selling low.
• “I’ve got five years to retirement; I don’t have enough saved — so I picked the most aggressive pension choice, right now it is returning 12 to 15 per cent. I have to make up for lost time.” What happens if there is a declining market for four out of those five years?
• “I don’t want to lose money, so am very uncomfortable with seeing my individual stock values go down. The market is at an all-time high. Why aren’t my investments up there, too? Distressed sectors and concentration of risk?
The answer to all of these comments, on a broad basis, is that it depends on numerous factors, but a large contributing one is what is the individual concentration of risk? It appears that each of these individuals have picked securities with high returns only.
Great choices. What is wrong with that?
Nothing! Except when markets fluctuate, crash momentarily due to tweets or other market disrupters, or move into recessionary environments, then the investor may see those great returns flip into great losses.
The mantra: high returns equal high risk (of loss) has not changed.
In the words of Ben Mcclure from Investopedia, “If you were to craft the perfect investment, you would probably want its attributes to include high returns and low risk. The reality, of course, is that this kind of investment is next to impossible to find.”
So, how do portfolio managers and experienced individual investors manage to minimise some of these risks?
By not putting all the eggs in one basket, otherwise known as Modern Portfolio Theory, originally developed by Harry Markowitz in 1952. Yes, almost three-quarters of a century ago.
Professor Markowitz shared the 1990 Nobel Prize for Economic Sciences with Merton H Miller and William F Sharpe. He is now 91 years old and still teaching at the University of California. He is best known for his pioneering work in modern portfolio theory, studying the effects of asset risk, return, correlation and diversification on probable investment portfolio returns.
Let’s take a look at how the theory encompasses diversification through asset allocation.
The simplest version of a diversified portfolio is the “rain portfolio” described in Ben Mcclure’s article as “a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn’t rain. Thus, both assets will always pay off, regardless of whether it rains or shines.”
Modern portfolio theory, or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximised for a given level of risk.
It is a formalisation and extension of diversification in investing, the idea that owning different kinds of financial assets is less risky than owning only one type. Its key insight is that an asset’s risk and return should not be assessed by itself, but by how it contributes to a portfolio’s overall risk and return. It uses the variance of asset prices as a proxy for risk.
Risk can be internal relative to the security itself, or derived from external market disrupters such as tweet barrages — unannounced, unexpected disparagements of some stock or organisation — the result of which the stock valuation takes a hit whether the pronouncement is true or fabricated.
Individual investors have to be completely gobsmacked when their stock selections are wilfully pounded for no other reason than that an influential person or politician has decided to do so.
Jack Dorsey, chief executive officer of Twitter, announced two days ago by a tweet that Twitter will start labelling tweets from public officials that violate the company’s rules. Twitter’s rules prohibit threatening violence against an individual or group of people, promoting terrorism and violent extremism, the sexual exploitation of children, abuse, harassment and hateful conduct.
And I leave you with that for today.
Next week, we will review various types of investment allocations to explore just how, risk is or isn’t managed depending upon your personal risk tolerance.
• Investopedia. Modern Portfolio Theory: Why It’s Still Hip By Ben Mcclure June 25, 2019 https://tinyurl.com/yyp3v8un
• Ray Dalio: Bridgewater Associates. Billionaire Ray Dalio — All Weather portfolio — shares a three-step formula for anyone to start investing. https://tinyurl.com/y7tc4br7
• Martha Harris Myron CPA CFP JSM: Masters of Law — international tax and financial services. Dual citizen: Bermudian/US. Pondstraddler Life, financial perspectives for Bermuda islanders and their globally mobile connections on the Great Atlantic Pond. Finance columnist to the Royal Gazette, Bermuda. All proceeds earned from this column go to The Reading Clinic. Contact: firstname.lastname@example.org