Risk inherent to the entire market or market segment is referred to as systematic risk and modern portfolio theory says that a blend of investments has the potential to increase overall return for a given level of risk, and/or decrease risk for a given return that the investor is trying to achieve. The expected risk/return relationship is known as the efficient frontier. [If you have a portfolio of investments then you need to fully understand what all this really means and how you can apply it to your portfolio makeup to enhance returns under any circumstances. Let me do just that.] Words: 1325
So says Alan Johnson (www.thereasonedinvestor.wordpress.com) in edited excerpts from his original article* which Lorimer Wilson, editor of www.munKNEE.com has further edited below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.
Johnson goes on to say, in part:
There are 2 kinds of risk – non-systematic and systematic.
In an earlier post I discussed the use of diversification as a means to mitigate non-systematic risk (i.e., risk that is unique to a specific company).
If, for example, you happen to be bullish on oil, investing in a fund that holds a variety of oil company stocks greatly reduces the severity of decline in your portfolio if one of the companies experiences an Exxon Valdez or BP Deepwater Horizon event. So diversification involves taking somewhat smaller positions in several companies that participate in similar markets.
Let’s now imagine that a major university reports that researchers have discovered a means by which zero point energy-based power generation systems can be commercialized, and with it the potential for electricity that is truly “too cheap to meter.” In this scenario, the stock prices of all oil companies in your fund, and thus the price of your fund itself, would plummet. This is an illustration of systematic risk, which is the risk inherent to the entire market or market segment.
It follows, therefore, that systematic risk can be mitigated by allocating one’s investments across various funds that represent dissimilar markets or segments. In portfolio theory, such dissimilarity is measured using a mathematical term known as correlation (which we’ll get into later).
A Simplified Illustration of Modern Portfolio Theory
Aside from mitigating risk, allocation has another advantage. This advantage is often illustrated conceptually using small business metaphors. For example:
- consider a landscaping business in the northeastern U.S. where I live. Profits are high in the spring and summer, dwindle somewhat in the autumn, and are practically non-existent in the winter. On a monthly basis, the ‘returns’ of this business would be highly volatile (albeit predictable). Let’s imagine profits of $10,000 a month for this small business from April through August; $5,000 a month from September through December; and $0 per month from December through March. Over one year our imaginary landscape business has generated $70,000 in profits. The monthly profits over the year range from a high of $10,000 to a low of $0.
- Our small landscaper has a couple of heavy-duty pick-up trucks for hauling equipment and supplies to the various job sites. Why not make a small additional investment in snow plow attachments and use these trucks to clear snow from driveways and parking lots during the winter months? Given the vagaries of the weather, let’s say that our landscaper now earns an additional $20,000 over the 4 months from December through March in his snow removal business. The monthly high of $10,000 and low of $0 may be unchanged, but the number of months in which profits are zero has decreased.
Two things have happened:
- Annual profit (or ‘return’) has increased from $70,000 to $90,000.
- Because some income is now coming into the business over the winter months, the monthly fluctuation in profits (‘volatility’) has been reduced.
So we see in this simple thought experiment that allocation has the potential to both increase returns and reduce volatility in a business and, by extension, an investment portfolio.
Understanding Modern Portfolio Theory as an Investment Concept
Our thought experiment [above] is a simplified illustration of a more complex investment concept known as modern portfolio theory. Let me try to walk you through this using the diagram below:
It starts with the simple premise that an investor logically expects to receive a ‘reward’ (i.e., return) that is commensurate with the risk he or she is taking in making the investment. In our diagram:
- Investment A has relatively low risk (as measured by the volatility, or extent of price fluctuation over time) but also has a relatively low annual return. Typically, a bond fund or some other type of fixed income investment would have these characteristics.
- Investment B, on the other hand, might be a stock or equity fund that has a higher expected return but carries a higher degree of risk as well.
- An investor willing to ‘split the difference’ in terms of risk in his/her portfolio might expect that holding 50% of A and 50% of B might result in a combination of risk and return midway between that of A and B as shown by point C on the diagram.
- Modern portfolio theory, however, says that assuming risk midway between that of A and B by blending the two investments in one’s portfolio will, in actuality, generate a higher return equivalent to point D.
- Moreover, point D is not the return one would receive in a portfolio consisting of a 50/50 mix of A and B. Instead, a 50/50 blend of A and B would result in a return equivalent to the average return of both investments, but at a much lower risk (degree of portfolio’s fluctuation in value) equivalent to point E on the diagram.
As such, modern portfolio theory says that a blend of investments has the potential to increase overall return for a given level of risk, and/or decrease risk for a given return that the investor is trying to achieve.
The Efficient Frontier
The blue curved line defining the expected risk/return relationship is known as the efficient frontier. Notice that, in moving from point A to point E by increasing the holdings of Investment B, a significant additional return has been received with only a small amount of additional risk but, as more risk is assumed beyond that point, the benefit in terms of additional return becomes smaller and smaller.
If you do a Google search on images for ‘efficient frontier’ you’ll find all sorts of complicated and interesting curves, with all of them having a convex shape to some degree and this convexity, illustrates what is sometimes referred to as the ‘free lunch’ of investing (the extent of which is shown by the green arrow in our diagram above).
The specific shape of the efficient frontier curve is influenced by such things as:
- the number of holdings in the portfolio,
- the risk/return characteristics of each holding, and
- the extent to which the returns of each holding are correlated with the returns of the other holdings.
- Systematic risk is the risk inherent to an entire market or market segment.
- Asset allocation can mitigate systematic risk and has the potential to both increase returns and reduce volatility in an investment portfolio.
- This is due to an aspect of modern portfolio theory which demonstrates that a blend of investments has the potential to either increase overall return for a given level of risk, or decrease risk for a given level of return that an investor is trying to achieve.
- These advantages are influenced by such things as the number of holdings in the portfolio, the risk/return characteristics of each holding, and the extent to which the returns of each holding are correlated with the returns of the other holdings.
The correlation aspect is one of the trickiest to manage. The idea is to select an appropriate number of asset classes with valuations that, while generally increasing, are not expected to move in precise tandem with each other over the investment holding period.
*https://thereasonedinvestor.wordpress.com/2010/08/15/using-asset-allocation-to-reduce-systematic-risk/ (To access the original article please copy the URL and paste it into your browser.)
Editor’s Note: The above article has been has edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.
Gold stocks have historically ranked among some of the most volatile asset classes – about three times that of gold bullion – but despite this volatility, our research shows that investors can use gold stocks to enhance returns without adding risk to the portfolio. [Let me explain.] Words: 560
Regardless of the size of your financial pyramid, without a core-holding foundation, you are building it on sand. Core holdings are for protection, not for profit. They function as insurance against a catastrophe. [Let me explain.] Words: 754
The traditional view of portfolio management is that three asset classes, stocks, bonds and cash, are sufficient to achieve diversification. This view is, quite simply, wrong because over the past 10 years gold, silver and platinum have singularly outperformed virtually all major widely accepted investment indexes. Precious metals should be considered an independent asset class and an allocation to precious metals, as the most uncorrelated asset group, is essential for proper portfolio diversification. [Let me explain.] Words: 2137
We are reading a lot of hype these days about gold and the necessity to own it but only about 2% of ‘investors’ actually have gold in their portfolios and those that have done so have insufficient quantities to offset the future impact of inflation and to maximize their portfolio returns. New research, however, has determined a specific percentage to accomplish such objectives. Words: 1063
There is a common notion that stocks, at least if held for a long-time, outperform other assets [and, as such,] should be the cornerstone of any long-term portfolio. [While that is indeed true,] it is best to focus first on how much you are able and willing to lose (i.e. what risk you are able and willing to bear) when determining the optimal allocation for your portfolio. [Only] then [should you] think about what potential investment returns you might be able to capture. [Let me explain.] Words: 1503
Most investors don’t know anything more about diversification than you “shouldn’t put all your eggs in one basket” [but] spending some time trying to understand the ways you might be shooting yourself in the foot could seriously enhance your portfolio returns and stop catastrophic risk. [There are some advantages to diversification if you REALLY know what you are doing but the shortcomings can go a long way towards killing your portfolio returns. In this article we identify what they are and how best to avoid them.] Words: 1055
What hope can there be for motivated stock pickers – no matter how much they sweat and toil – to outperform the low-cost index funds that simply mechanically track the market? Well – in spite of the absurd rise of the Nobel-acclaimed, and highly promoted, Efficient Market Hypothesis that claims that individual investors can’t beat the market – it turns out there is plenty! Just ask Warren Buffett, for one. [Let me explain.] Words: 1574
The amount of evidence stacking up that…mutual funds…do not provide value for their investors is just staggering…While there are certainly signs that the public’s tolerance of excessive fees and executive pay is falling, the likelihood of significant structural change in the finance industry is still remote. Given such a backdrop the probability remains that investors in funds will, on average, continue to underperform their benchmarks. So what is an investor to do? [Read on!] Words: 830
While the average amateur investor may be excellent in their own career field, it doesn’t mean they know what to invest in, or how to pick stocks. In fact being very good at your field can give you the false sense that whatever stocks you pick or your broker picks for you must be good, because after all, you picked them and you picked your broker — and you’re smart so, no doubt, those stock prices will go up. Unfortunately, the smart and talented stock-picking neophyte is not investing at all but speculating. Words: 924
Although the stock market is the first place in which many people think to invest, the U.S. Treasury bond markets arguably have the greatest impact on the economy and are watched the world over. Unfortunately, just because they are influential, doesn’t make them any easier to understand, and they can be downright bewildering to the uninitiated. [This article provides you with an excellent understanding of what bonds are, the advantages of owning them and how to go about trading them.] Words: 1325