Portfolio theory - Can it be used?
In this blog, I want to cover the topic of portfolio theory, and ask the question, can it be used? It was developed by Markowitz in 1952 and the idea of it is best described with the image below. Portfolio theory is managing risk against return, so ultimately, it allows investors to construct a portfolio by aiming to optimise their expected return or to minimise their risk. So, the question is, if it is so simple, then why is this theory not followed by all investors, or at least Markowitz himself? (Markowitz, 1952).
Portfolio Theory Model
The model weighs up suspected risk against a return, and thus allows an investor to be as risk averse as they like. It is important to question an investors risk level, along with the risk free rate when identifying a portfolio. The model has two parameters, standard deviation and the return that is expected to be generated.
The lower left curve of the graph shows the minimum possible risk free rate, although it is technically the point where an investor will not accept any additional risk, in practice though, it does not exist as even what you would consider a safe investment still carries a small amount of risk.
The curve on the graph allows investors to construct their own portfolios with assets that obtain various levels of risk. When choosing assets, investors can use CAPM.
CAPM stands for capital asset pricing model. An investor uses this to calculate their required rate of return for potential risk. The formula can be found here! (ACCA, 2014). This allows investors to analyse the time value of their investments with its risk. Ultimately, it shows the amount of compensation they would need to make the investment worthwhile, by comparing returns to market averages.
Diversification
This is whiteout doubt, the most important question that investors ask, how much should you diversify?
'Diversification is protection against ignorance' - Warren Buffet.
While it is not possible to escape all systematic risks, as they effect all investments, diversification does, however, allow an investor to reduce any unsystematic risk. Furthermore, benefits have been seen with investors purchasing foreign stocks, in an effort to reduce correlation (Choe et al. 2005). This means that a downturn in the UK's economy, may not necessarily affect stocks in the Chinese market.
Most argue that the average investor will maintain a 60/40 split with their bonds and equities, and even those investors that take on more risk, are only investing in around 6 funds, making it more manageable to track their money. Despite this, studies have shown that investors seeking the most cost effective level of reduced risk, will diverse in as many as 25-30 stocks (Statman, 1987).
Investors must remain wary of poor investment choices, as quantity does not reflect quality as poor stocks will reflect in below market returns (Malkiel, 2003). A complex portfolio reduces the time an investor can spend focusing on a portfolio, which can result in delayed action to a market downturn. Investors must ensure they are gaining good value on their shares. For those would like to understand more on shareholder value, please read my other blog, shareholder valuation methods.
Theories and issues
When reading Arnold, he mentions a number of theories relating to portfolio theory that are either widely accepted, or are seen as being controversial.
Accepted Theories
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Controversial Theories
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- Shareholders want a higher return for a riskier asset
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- When Beta is calculated via past returns, it is valid for future decision making
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-Risk averters will diversify
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- Systematic risk is measured by Beta. However, this is calculated as the degree of co-movement of a shares return in the market index. It is argued that CAPM-Beta is one of a number of systematic risk factors that influence a shares return
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- The risk of an asset is affected by specific firm factors that can be diversified away and factors common to all firms
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- shares have different levels of sensitivity to systematic risk elements
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(Arnold, 2012)
Issues do arise when this theory is applied in practice, and one of the main issues is that it is based on a number of assumptions. It states that investors will trade at a risk free rate, however, as previously mentioned, when put in practice this point does not exist.
It also assumes that there is no tax or transaction costs. However, this is simply not true. Every time a security is purchased or sold, it incurs a transaction cost, which ultimately dilutes your return. So, by ignoring something that occurs on each purchase, does it make Markowitz theory lack credibility? By taking some of these issues into account, you have to ask, is it easy for investors to implement the theory?
Portfolio theory makes investment decisions based on historic data and correlations within that data. For it to work, shares within the portfolio must be stable in order to predict potential returns. Further to this, I mentioned above that most investors suggest having a portfolio of no more than 6 securities. This is to better manage a portfolio, but for investors who go beyond this, it can be very difficult to manage when their portfolio hits a number of complications and issues.
Conclusion
It seems clear that Portfolio theory brings its complications. The fact that it makes a number of assumptions, ignores some pretty obvious issues, such as transactions costs, can be difficult to implement and that fact most that have studied the theory do not use it themselves, suggests that this theory should not be followed wholeheartedly. Even Markowitz himself has said that he splits his portfolio 50/50 between stocks and equities.
Furthermore, portfolio theory doesn't really tell an investor how to invest, or how to choose their portfolio, only that diversifying will reduce their risk. It is important to note that diversifying is not easy. The purchased stocks still need to be researched so the investor is confident of a good return.
Therefore, it seems that for todays investors, this theory will provide a good understanding to how others see the market, but an investor can not use it to base their trading.
Furthermore, portfolio theory doesn't really tell an investor how to invest, or how to choose their portfolio, only that diversifying will reduce their risk. It is important to note that diversifying is not easy. The purchased stocks still need to be researched so the investor is confident of a good return.
Therefore, it seems that for todays investors, this theory will provide a good understanding to how others see the market, but an investor can not use it to base their trading.
References
Arnold, G. (2012). Corporate Financial Management (5th ed.). London, UK: Pearson. Choe, H., Kho, B. C., & Stulz, R. M. (2005). Do domestic investors have an edge? The trading experience of foreign investors in Korea. Review of Financial Studies, 18(3), 795-829. Retrieved from http://fisher.osu.edu/supplements/10/10402/Do-domestic-investors-have-edge.pdf |
Harry Markowitz, (1952). The Journal of Finance, 7(1), 77-91. Found at:
http://links.jstor.org/sici?sici=0022-1082%28195203%297%3A1%3C77%3APS%3E2.0.CO%3B2-1
Malkiel, B. G. (2003). The efficient market hypothesis and its critics. Journal of economic perspectives, 59-82. Retrieved form http://www.vixek.com/Efficient%20Market%20Hypothesis%20and%20its%20Critics%20-%20Malkiel.pdf
Statman, M. (1987). How many stocks make a diversified portfolio?. Journal of Financial and Quantitative Analysis, 22(03), 353-363. Retrieved from http://deutschlandlerntsparen.de/wp-content/uploads/2013/10/How-Many-Stocks-Make-a-Diversified-Portfolio.pdf
Interesting conclusion, to a certain extent I agree with your view. However, I do believe that the type of investor will impact whether this theory can be applied. Do you not think that this theory would be useful to implement as an active investor?
ReplyDeleteInteresting, how long do you feel you should aim to hold on to these shares or bonds?
ReplyDeleteI personally like the model as a brief guideline as it takes into account investors who are willing to take risks and those who are not. Do you think if the Capital Asset Pricing Model line was applied it makes the Portfolio Theory more applicable or more controversial?
ReplyDeleteSam: I would say that it would be more useful to active investors, who aim to be constantly involved with their portfolio.
ReplyDeleteDayle: The CAPM model assesses the relationship between risk and return, and so I would say that makes it more controversial. This is because the ignorance of tax and transaction costs distorts any results that are produced.