Modern Portfolio Theory

Passive vs. Active Management

1) Passive portfolio management 
Refers to setting up a portfolio to match the entire stock market or some well-known index as closely as possible. When established, these portfolios are simply left alone to fluctuate along with the indicator that the portfolio is set up to follow.

2) Active portfolio management 
Involves regularly changing the contents of a portfolio. Every portfolio manger has his own strategies and methods for analyzing and optimizing returns but the point is that the portfolio manager is buying, selling and trading the underlying investments actively. He may try to take advantage of short-term fluctuations in price by making multiple trades every day.

Regardless of the approach you take, actively managing a portfolio is a full-time job. It entails constantly re-evaluating existing investments, searching for new investments and assessing the degree of risk and the returns being generated by the portfolio as a whole.

Efficient Market Hypothesis

The efficient market hypothesis states (incorrectly) that the market responds instantly to new information, ensuring that all investments and assets are valued at their fair market price.

According to the hypothesis, if people all have the same information at the same time and have equal access to exchange markets, prices adjust instantly to their economic equilibrium.

If the efficient market hypothesis were true, any opportunities to generate returns on investments are useless because all investments instantly change to their proper price whenever new information becomes available.

After all, not everyone has the same information; some people know more than others and many receive information at different times and process it in different ways. In addition, people don’t have equal access to exchanges.

The decisions that people make regarding investments vary as well because investors react to news in different ways, have different strategies and measure the value of stocks differently.

The market is efficient only in the long term. In the short term, frequent and intense levels of volatility can push the value of an asset, investment or even an entire company well away from its real value.

Risking Returns

Risk is an unavoidable part of corporate finance. If a company were to try to eliminate financial risk, all operations within the entire organization would come to a standstill.

Instead of trying to avoid risk, companies tend to make choices that have the biggest differential between risk and financial returns. They measure the amount of returns they expect on a potential investment and determine the potential costs associated with the risks of that investment. Then they use mathematical modeling to determine their best investment option.

In portfolio management, you can minimize the level of total risk and still maximize financial returns by carefully measuring how different investments change in value compared to each other in multi-asset interactions.

Trade-off between Risk and Return 

A central tenet of modern portfolio theory is that a trade-off exists between risk and return. All things being equal, if a particular investment incurs a higher risk of financial loss for prospective investors, those investors must be able to expect a higher return in order to be attracted to the higher risk.

Just because an investor believes that a higher risk investment is going to generate higher returns doesn’t necessarily make it true. Sometimes higher-risk investments become less risky over time, attracting more investors who then drive up the price/value of the investment by competitively outbidding each other.

Whether or not a riskier investment does generate higher returns is up to the individual investor to decide. 

– how risk is assessed and the amount or expected returns, changes depending on the individual investor.

– investors will invest in higher-risk opportunities if they feel that doing so is going to generate higher returns.

Diversifying to Maximize Returns and Minimize Risk

The risk of a single investment can’t be completely eliminated so companies attempt to reduce the risk of a portfolio by picking investments that are likely to change in value in different ways or at different times. This process is known as diversification.

It means taking advantage of differences in risk among your investments and the fact that investments tend to change in value at different times and even in different directions. So if your portfolio consists of several different investments and only one of them loses value, the portfolio loses a smaller percentage of its value than a single investment does.

Goal of Diversification 

To reduce risk by finding several investments that change in value at different times, in response to different events, by different percentages or in completely different directions.

In this way, you reduce the severity of any losses that may occur in a portfolio from the risk associated with only one investment. You can measure the effectiveness of portfolio diversification mathematically which we will cover later.

So why don’t companies just invest all their money in only the best assets instead of diversifying? 

Warren Buffet, CEO of Berkshire Hathaway Inc., claims that diversification is used only when a company lacks confidence or ability, maintaining that diversification is a tool only for the incompetent. Thus, diversification simply for the sake of diversification isn’t very helpful. The point of diversification is to reduce the risk to your portfolio more than you reduce the returns.

Let’s look at an example.

Say that Investment A generates 10% annual returns, Investment B generates 5% annual returns and your portfolio has an equal split between Investments A and B. X is the amount of portfolio risk as a percentage of total value. In this example, 7.5% is the amount of annual returns generated by the portfolio.

Thus, you want to look for the best investments you can find and then diversify by purchasing those investments that provide the highest returns but risk losing value under directly opposite conditions.