Much of what we consider as ancient and unquestioned fact about investing and building portfolios was actually a set of innovations developed by a brilliant finance professor named Harry Markowitz. Originally published in 1952 in the Journal of Finance, Modern Portfolio Theory (MPT) is an investment theory based on the idea that investors can build portfolios to optimize expected return based on a given level of market risk. A foundational premise of the theory is that risk is an inherent part of higher reward.
The basic idea is that investors can specify a level risk that they are willing to tolerate and that there is an optional portfolio allocation for that level of risk. In other words, there is an optimal portfolio for all risk levels. By optimal, we mean that returns are maximized. Markowitz showed that investment is not about picking stocks, but about choosing the right combination of investments to hold in your portfolio.
In MPT, risk is defined as deviation from the mean of a benchmark. An individual stock, for example, can return less than the average, and that is the risk of owning that stock. From this thesis, we can see why diversification is so important. The return from a basket of stocks is less likely to deviate substantially downward from the average than any single stock.
This benefit of diversification only works if the basket of stocks is uncorrelated. When we talk about two (or more) things being correlated, we mean that changes in value happen in tandem. In other words, they go up together, and they go down together. Let’s say you invest in Bob’s Snow Cone Stand. You did very well on this investment, so you decide to buy stock in Linda’s Ice Cream Emporium. During an exceptionally long, cold winter, both investments perform poorly because people (hypothetically) don’t want to each cold stuff like snow cones and ice cream when it’s freezing outside.
Because of this hypothetical weather dependency, both of your investments are highly correlated. They go down in tandem, and your portfolio reflects the damage. Had you invested in Cindy’s Coffee Cafe, you would have incurred less risk. We would expect sales of hot coffee to increase during the winter months, which would offset the decline in snow cone sales that make your other investment profitable. In other words, there is an inverse correlation between the profits (and thus the equity price) of the two companies.
If you listen to the talking heads on television, you may hear something like “tech is having a bad day today.” This is because tech stocks tend to be highly correlated; they move up and down as a group. If all you have in your portfolio is tech stocks, then your portfolio will move down to the degree that tech stocks are correlated. The reason some investors are willing to take that risk is that a small basket of tech stocks can have explosive upward potential. In other words, you can make a lot of money quickly if you are willing to accept the possibility that they can also move down together in a big way causing horrible damage to your portfolio.
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Last Updated: 6/25/2018