If you are aware of the saying “do not put all your eggs in one basket” then you can easily understand the basic principles of portfolio management. Asset allocation and Modern Portfolio Theory, or simply portfolio selection (or portfolio management), are complementary. Asset Allocation is just the application of putting the eggs in several baskets. Modern Portfolio Theory is about how to allocate your funds efficiently, in a quantitative manner. Modern Portfolio Theory is based on “Portfolio Selection” one of the most pioneering and influential research papers in Financial Economics, written by the Nobel Laureate Harry Markowitz. By forming optimal and well diversified portfolios you can significantly increase the chances of making money in the stock market.
Modern Portfolio Theory is based on the power diversification. Consider owning a particular stock of a company belonging to the S&P 500 Index. In a favorable but extreme scenario, you may double your money within a couple of months. However in an unfavorable extreme scenario the company may go bankrupt and lose all your money. Now compare that to possessing a Dow Jones Industrials index fund which invests in 30 of the U.S. largest corporations. Dow Jones Index companies are not likely to double in value in a couple of months, but neither are likely to go bankrupt simultaneously. Thus, with a diversified portfolio you can limit rare event risks as well as reduce the volatility of your portfolio.
By selecting an optimal and well diversified portfolio, an investor, minimizes the so called unsystematic or stock-specific risk. This type of risk is related with the various types of risk of individual companies such as bankruptcy risk. Unsystematic risk can be “diversified away” as the number of stocks in a portfolio increases. Many investment professionals and researchers claim that a portfolio of 20 stocks is well diversified in the sense that unsystematic risk is low. On the other hand, systematic risk cannot be “diversified away”. Systematic risk refers to economy-wide risks and conditions such as changes in monetary and fiscal policies, recession risks and significant geopolitical events.
Investment professionals and practitioners choose an investment portfolio that will hopefully deliver the highest possible return for the desired degree of investment risk. It makes sense to accept that higher returns are likely to be delivered by riskier investment opportunities. Therefore, an investor with high risk tolerance can get a high return choosing a portfolio concentrated to risky assets. However, under normal circumstances, a risk averse investor cannot get the same high return without accepting a higher degree of risk.
Portfolio management, at least from an academic perspective, is neither about market timing nor about stock picking. In other words, optimal investment management is not just about picking the right stocks, but about choosing the right portfolio of stocks to achieve the optimal risk-return tradeoff that satisfies the investor’s risk appetite.
The Theory of Portfolio Management is compatible with the Efficient Market Hypothesis. The Efficient Market Hypothesis claims that it is not possible to generate high returns simply by utilizing superior methods and information. In other words, it is impossible to generate high returns without accepting significant risks. The Theory of Efficient Markets was the key factor for the introduction and popularity of index funds some decades ago.
StockTradingCollege.com, Stock Trading and Investing for Beginners
Modern Portfolio Theory is based on the power diversification. Consider owning a particular stock of a company belonging to the S&P 500 Index. In a favorable but extreme scenario, you may double your money within a couple of months. However in an unfavorable extreme scenario the company may go bankrupt and lose all your money. Now compare that to possessing a Dow Jones Industrials index fund which invests in 30 of the U.S. largest corporations. Dow Jones Index companies are not likely to double in value in a couple of months, but neither are likely to go bankrupt simultaneously. Thus, with a diversified portfolio you can limit rare event risks as well as reduce the volatility of your portfolio.
By selecting an optimal and well diversified portfolio, an investor, minimizes the so called unsystematic or stock-specific risk. This type of risk is related with the various types of risk of individual companies such as bankruptcy risk. Unsystematic risk can be “diversified away” as the number of stocks in a portfolio increases. Many investment professionals and researchers claim that a portfolio of 20 stocks is well diversified in the sense that unsystematic risk is low. On the other hand, systematic risk cannot be “diversified away”. Systematic risk refers to economy-wide risks and conditions such as changes in monetary and fiscal policies, recession risks and significant geopolitical events.
Investment professionals and practitioners choose an investment portfolio that will hopefully deliver the highest possible return for the desired degree of investment risk. It makes sense to accept that higher returns are likely to be delivered by riskier investment opportunities. Therefore, an investor with high risk tolerance can get a high return choosing a portfolio concentrated to risky assets. However, under normal circumstances, a risk averse investor cannot get the same high return without accepting a higher degree of risk.
Portfolio management, at least from an academic perspective, is neither about market timing nor about stock picking. In other words, optimal investment management is not just about picking the right stocks, but about choosing the right portfolio of stocks to achieve the optimal risk-return tradeoff that satisfies the investor’s risk appetite.
The Theory of Portfolio Management is compatible with the Efficient Market Hypothesis. The Efficient Market Hypothesis claims that it is not possible to generate high returns simply by utilizing superior methods and information. In other words, it is impossible to generate high returns without accepting significant risks. The Theory of Efficient Markets was the key factor for the introduction and popularity of index funds some decades ago.
StockTradingCollege.com, Stock Trading and Investing for Beginners