Many people are scared of investing in stocks because they have heard that they are very risky. Then on the other hand you have people who take investing risks that they don’t need to take in order to try to get a higher return. Well today I hope to answer some questions for people on both sides.
Modern Portfolio Theory
You may have heard the phrase Modern Portfolio Theory but what is it and how can it help your portfolio?
Modern Portfolio Theory- An idea originated by Harry Markowitz in 1952 explaining the benefits of diversification, and the correlation of risk and return in an investment portfolio.
Harry Markowitz eventually won the Nobel Prize in Economics for his research on this topic. He stated that as you add to the number of holdings in your investment portfolio, your risk should in turn go down.
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.” 1.
Modern Portfolio theory states that diversification helps to take away the unsystematic risk that comes along with any stock or even category of stocks.
The Efficient Frontier
Below is a chart created by Matson Money using the principles that Harry Markowitz found and taught. The chart explains that for whatever amount of risk you are willing to take, there is an optimal return that you can get for that risk level. The level of risk or volatility is measured by standard deviation.
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There are 5 points on the chart that I would like to explain. The first 4 are Matson Money portfolios. The conservative portfolio is made up of 25% stocks and 75% fixed. Moderate is 50/50, Growth is 75% stocks and 25% fixed, with Aggressive being 95% stocks and 5% Fixed. Those 4 portfolio types fall on the efficient frontier. This means that they are diversified to the point of efficiency and reach the highest expected return for the specific risk that you are taking. Any point that is above that line is impractical in the long term, and anything below the line is inefficient.
Should I Just Invest in the S&P 500?
Notice the S&P 500 is well below the efficiency line. This means that for the amount of risk that is inherent in that group of stocks, the return is not optimal. This is due to a few reasons; it only includes 500US stocks out of the almost 13,000 total stocks possible to own in the world, it does not include small or value companies with higher expected returns, nor does it include any fixed income to keep the standard deviation down. If you wanted you could invest in a diversified growth fund and increase the expected return while decreasing the risk. Keep in mind this chart and data is based on past performance, and past performance is no guarantee of future results.
The coolest thing about this is that the average investor can invest in a diversified portfolio that fits their risk tolerance by the way it is designed and know exactly what the risk and expected return is up front.
We have software that can take your specific investments and show you exactly where you fall on the efficient frontier. If you are interested contact us today.
By Jimmy Hancock
References
1.”Modern Portfolio Theory: Why It’s Still Hip.” Investopedia. Investopedia US, n.d. Web. 13 Oct. 2014. <http://www.investopedia.com/articles/06/mpt.asp>.
2.Matson Money. TheEfficientFrontierPowerpoint. N.p.: Matson Money Inc., 6 May 2014. PPT.