Why You Must Know Portfolio Management Before Investing
Investing Is More Than Just Stock Picking
When asked what we know about investing, we often think of Warren Buffet the Sage of Omaha whose investment principles have made him one of the most successful investors in the world. Perhaps you have read books such as “The Intelligent Investor” and learned about the concept of value investing. Quotes such as “Price is what you pay; value is what you get” and “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes” have taught you to focus on the long term and the intrinsic value of a company. And maybe you have come to see the market as a maniac-depressive, driven by fleeting spells of optimism and pessimism.
While these concepts serve as excellent mental models, by focusing only on value investing and stock selection, we run the risk of losing the forest for the trees. Stock selection while important is only a small part of investing. We invest to accomplish our financial goals, be it buying a house or retiring before the age of 50. At the core of it all, we hope that investing can help us attain the life we dream of and hope for. Unfortunately, while we have seemingly an infinite number of opportunities to invest in, what we lack is time. Every wrong decision we make takes us further from our goals until eventually we run out of chips and get kicked out of the casino of life. Thus, at the heart of investing is the desire to meet our financial goals with as little risk of failure as possible. These two desires form the core motivations of portfolio management: to maximise a portfolio’s expected return while minimising risk.
Modern Portfolio theory
Pioneered in 1952 by Harry Markowitz, who subsequently won the Nobel prize for his work, Modern Portfolio Theory seeks to provide a portfolio management framework for risk-averse investors to maximise return while minimising risk. The core concept of the theory is that the risk and return features of an investment should not be interpreted individually, but should be assessed together with the overall portfolio.
I am sure many of you have heard that diversification is the only free lunch in investing. Though, what is often left out is the principles behind diversification. Thus, we often “split our eggs into different baskets” by buying different kinds of stocks, which does not fully leverage the power of diversification. In this article, I will be going through the theory of portfolio management before explaining what it means for you. As such, do skip over to the end if you are more interested in the results.
An example using 2 Assets
Say you have two assets, stock A and B, which each have a specific return and risk. (Risk here being defined as it’s volatility which mathematically is its variance) You can now plot and compare these 2 stocks on the following graph.
Those points on the graph represent the expected return and risk you would be taking if you invested 100% of your money into either of those stocks. However, can you predict what happens when you split your money into these 2 stocks? Here is the graph depicting the results. (P representing the correlation of the 2 stocks to each other)
What you notice is that as the stocks become increasingly uncorrelated(P=1-> P=-1), the line curves increasingly to the left. This means that for any given risk taken, you can obtain higher returns. The red portions of the graph represent portfolios that are suboptimal as there exists a portfolio that can provide a higher return for the same level of risk. Moreover, if you are risk averse, you can invest in the Minimum Variance Portfolio (MVP) which is the portfolio with the lowest risk.
If you are interested in the math behind it do head over to this article:
Demystifying the Magic of Modern Portfolio Theory
Making Things More Efficient Using Risk-Free Assets
By following this line of thought, and adding more and more assets into the portfolio, you can hypothetically construct a set of optimal portfolios that offer the highest expected return for a given level of risk. This forms what economists call the efficient frontier, illustrated in the picture below.
Still, we can obtain even lower risk by adding Risk-free assets into our portfolio. In the real world, the closest substitute for a risk free investment are debt-obligations issued by the US treasury such as Treasury bonds. By incorporating these bonds into our portfolio, we form the Capital Market Line represented in yellow.
The Capital Market Line represents portfolios which have the highest possible Sharpe ratio. Additionally, it is tangent to the efficient frontier, where the point it meets the efficient frontier is the Market Portfolio.
What is the Sharpe Ratio?
An additional layer above what we have been discussing would be maximising the return of the portfolio with respect to risk. This is calculated using the Sharpe ratio which measures the performance of an investment compared to the risk-free asset, after adjusting for its risk.
The higher the Sharpe ratio the better a portfolio’s performance relative to risk taken.
The gradient of the Capital Market line is essentially the formula for the Sharpe ratio, which means any portfolio that lies on the capital market line has the highest Sharpe ratio. As such, any rational investor should invest in portfolios on the Capital Market Line because it maximises their risk adjusted returns.
What is the Market Portfolio?
The Market Portfolio is a combination of risky assets that produces the highest Sharpe ratio. Moving up the Capital Market line from the y-axis to the market portfolio would mean increasing the allocation of your portfolio in the risky assets until you reach 100%. However, Modern Portfolio Theory also assumes that a rational investor would borrow at the risk-free rate to leverage their investments. By doing this you can take your allocation above 100%, taking on a higher risk to increase return.
So How Does This Affect How You Manage Your Portfolio?
Diversification using Correlation
While we all know that we need to diversify, many of us are doing it wrongly by buying many different stocks. At the heart of Modern Portfolio Theory is the emphasis on correlation. Buying multiple stocks will not help unless they are lowly correlated. Unfortunately, major price fluctuations often affect the entire stock market causing them to move in tandem. As such, stocks are often highly correlated, meaning the 2 eggs you are splitting are actually ending up in the same basket. The solution? Investing across asset classes, or as Ray Dalio puts it “15 uncorrelated return streams” Here is a picture depicting the correlations between asset classes. Although it is hard to find so many asset classes to invest in if you are a retail investor, applying this concept of portfolio management modestly can greatly improve you return to risk outcomes.
Importance of Risk-Adjusted Returns
We often focus far too much on the outcome of our investment decisions instead of the process. Yes, you made a ton on Bitcoin this year (rising from $5000 to $29000), but how much risk did you take? Another key takeaway from Modern Portfolio theory is the importance of risk versus reward. By applying the concept of the Sharpe ratio, investments are no longer simply regarded as “high risk, high reward” or “low risk, low reward”. Instead, they will be considered through the lens of its specific risk to return characteristics: How much risk are you taking to achieve this level of returns?
I have also written an article that goes in-depth into whether you should invest in Bitcoin do check it out here: Should You Buy Bitcoin? An In-depth Analysis
How Should You Select Your Portfolio?
From the capital allocation line, you will notice that there exists a portfolio for any given risk level. What this means is that by varying your allocation in risk-free bonds, you can essentially select any portfolio that has a suitable risk level for you. So the question of portfolio selection now becomes: how much risk are you willing to take?
There are many answers to this question, but here are the most common ones.
1. What is your age?
If you are younger, you can take a higher level of risks because you have a much longer timeframe to recoup losses. A common portfolio allocation rule states that individuals should hold a percentage of stocks equal to 100 minus your age while allocating the rest into low-risk assets like bonds. Essentially common advice is to invest more into low-risk assets to decrease your risk level as you become older.
2. What is your risk tolerance level?
Not everybody can deal with losing large amounts of hard-earned money overnight, which happens often in the volatile stock market. A case in point, the SNP 500 index dropped over 30% in the pandemic. By investing in safer assets, your portfolio will be far less volatile. Moreover, bond prices often rise when stocks are falling, acting as a counterbalancing force to protect your capital. As always, the “sleep test” (whether you can sleep while holding that portfolio) would be a good indicator.
3. Are you retired?
Retirement changes the objective of your portfolio slightly. Before retirement, you would have been contributing monthly to the portfolio, and your portfolio objectives would have been to maximise your returns. After retirement, while your portfolio will still have the overarching aim to maximise returns (under an appropriate level of risks), it will now need to provide regular income. To solve this, most people start investing in dividend-paying stocks. However, dividends and stock prices fall during economic downturns, forcing you to start selling your undervalued stocks to support yourself. This is a huge reason why bond allocations rise after retirement. The bonds serve not only to decrease the risk of the portfolio but also to act as “reserves” to tap into during recessions. As bond prices rise during such periods, you do not have to sell your undervalued stocks, thus saving them to be sold subsequently after the economy recovers.
Leveraging
If you refer back to the capital market line, you will see that there exist portfolios above the market portfolio. These portfolios can be achieved by borrowing money to invest, allowing you to multiply your returns. Retail investors usually achieve this by buying on margin, or by purchasing options and futures. So you may be thinking, “I am in my early twenties, should I take even greater risk by using leverage?” Well, common investment consensus recommends retail investors to not use leverage. One of Warren Buffet’s most famous sayings is: “Rule №1: Never lose money. Rule №2: Never forget rule №1.” This is not surprising due to a mathematical fact known as negative geometric drag where losses matter far more than gains. For example, if you gain 20% and subsequently lose 20%, you end up with only 96% of your initial capital. By investing using leverage, you are multiplying your losses far more than gains. Moreover, interest rates are often high when leveraging. For example, margin interest rates can rise as high up as 10%. The Capital Market line assumes that you can borrow at the risk-free rate to leverage which is not achievable by retail investors. Here is how the line could look.
As you can see the line is kinked after the market portfolio, reflecting the higher rates to be paid to obtain leverage. As the gradient of the line is the Sharpe ratio, leveraging actually causes your portfolio to be far less efficient.
Knowledge of Portfolio Management Changes How You Invest
Modern Portfolio Theory has its fair share of criticisms, from the difficulty of forecasting returns for the assets to ever-changing correlation numbers making it difficult to calculate an optimum portfolio. However, applying the concepts of the theory allows us to visualise our portfolios with respect to the efficient frontier. Perhaps you will notice that your portfolio is not diversified even though you are holding many different stocks. Or maybe you will realise that you are holding far too little bonds for your age. Regardless of the difficulty of calculating the efficient frontier, an understanding of portfolio management will bring us a step closer to a portfolio that will stand the test of time and buy us the life we desire.
Check out my other articles here: The Finance Brief
Originally published at https://thefinancebrief.com on January 4, 2021.
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