Client Primer: Investment Theory
An early description of theory and markets came from the 1900 dissertation of French mathematician Louis Bachelier: “Past, present, and event discounted future events are reflected in market price … the determination of these fluctuations depends on an infinite number of factors; it is therefore impossible to aspire to mathematical prediction of it …”
A few decades later, the Cowles Commission for Research in Economics (home to academics such as Nobel laureates James Tobin and Harry Markowitz) published its research on market forecasting by summarizing that the markets outperformed forecasters.
A 1934 landmark publication, Security Analysis by Graham and Dodd, heralded the age of fundamental analysis. Graham and Dodd stressed balance sheet analysis (the “fundamentals”). The authors strongly recommended that a stock should only be purchased when its fundamentals met or exceeded a number of criteria. Their focus was on individual stocks, not the portfolio.
The most famous and successful disciple of Graham and Dodd has been Warren Buffett: “Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value…. While they differ greatly in style, these investors are mentally always buying the business, not buying the stock.”
Using a far different approach, Harry Markowitz—beginning with his 14-page March 1952 article in the Journal of Finance, “Portfolio Analysis with Factors and Scenarios”—wrote, “You should be interested in risk as well as return.” Markowitz’s premise was simply genius: risk is central to investing; and the portfolio, not a particular position, is fundamental for investment management. Harry’s original article evolved into his 1955 thesis; the full description was published in 1959 as Portfolio Selection: Efficient Diversification of Investments. This work is now referred to as modern portfolio theory.
Suppose you have two stocks or even two asset categories; each position has an expected return of 10% a year and a standard deviation of 10%. Prior to Markowitz, the standard deviation of a 50/50 portfolio of these two assets was believed to be 10%. In fact, the standard deviation of such a portfolio would only be 10% if the two positions had a perfect correlation coefficient (1.0). Suppose the correlation were 0.5 (considered random). The standard deviation for the portfolio would then drop to 8.7% (a 13% decrease). Now consider an equally weighted two-asset class portfolio constructed from two of the following three investments:
|
|
Return |
Std. Dev. |
Correlation with A |
|
Investment A |
8% |
15% |
|
|
Investment B |
6% |
10% |
0.3 |
|
Investment C |
6% |
8% |
0.9 |
Here, the focus should be on correlation coefficients, particularly since B + C are expected to have the same return. And even though C has a standard deviation higher than B, the advisor should choose A + B because the overall portfolio’s risk level is lower than it is with A + C.
|
|
Return |
Std. Dev. |
|
Investment A + B |
7% |
10.2% |
|
Investment A + C |
7% |
11.2% |
When looking at systematic risk (which cannot be diversified away) and unsystematic risk (which can be completely eliminated), it has been shown that a portfolio of 10–12 poorly correlated stocks eliminates the vast majority of unsystematic risk. This is quite desirable since there is no net benefit to having unsystematic risk.
Markowitz’s efficient frontier, which shows the most efficient (highest) return for each level of risk, presents numerous important concepts:
- There is no perfect portfolio.
- There are an infinite number of efficient portfolios.
- Efficient portfolios fall along the efficient frontier.
Current portfolios may be improved by repositioning assets resulting in
- greater return with the same risk level as the current portfolio,
- same return but less risk than the current portfolio, or
- greater return and sometimes less risk.