Contemporary
Portfolio Theory
The
history of investing in the United States is divided into two
periods: before and after 1952.
Why?
Well,
it was the year that an economics student at the University of
Chicago named Harry Markowitz published his doctoral thesis which is
now known as Modern Portfolio Theory.
How
important was Markowitz's paper that he received a Nobel Prize in
economics in 1990 because of his research and its continuing effect
on how investors line of attack in investing today.
It
starts out with the assumption that all investors would like to elude
risk on every occasion possible and defines risk as a standard
deviation of expected returns.
Rather
than look at risk on an individual security level, Markowitz proposes
that you measure the risk of an entire portfolio.
When
considering a security for your portfolio, don't base your decision
on the amount of risk that carries with it.
As
an alternative, consider how that security backs to the overall risk
of your portfolio.
Markowitz
then considers how all the investments in a portfolio can be
anticipated to move together in price under similar conditions called
"correlation," and it measures how much you can expect
variation of different securities or asset classes in price relative
to each other.
For
example, high fuel prices might be good for oil companies, but bad
for those who need to buy the fuel.
As
a consequence, you might expect that the stocks of companies in these
two industries would often move in conflicting directions.
These
two industries have a negative (or low) correlation. You'll become
better in the diversification of your portfolio if you own one
airline and one oil company, rather than two oil companies.
When
you put all this together, it's completely possible to form a
portfolio that has much higher average return compare to the level of
risk it contains.
So
when you build a diversified portfolio and spread out your
investments by asset class, you're really just managing risk and
return brought by the asset rather than the asset itself.
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