Friday, August 04, 2006

Risk, Return and the Markowitz Portfolio Theory

Harry M. Markowitz won the 1990 Nobel Prize for telling the world two fundamental truths about investment: "Higher risk, higher return" and "Don't put all your eggs in one basket". Much as I sounded as if he deserved the Novena Primary School Mathematics Competition Runner-up, I must point out that his findings were mathematically elegant. (I know you are saying "yeah right" but trust me, it's true, I was genuinely amazed by the beauty in its simplicity.)

Nevertheless, the important implications of his modern portfolio theory still hold true in today's investment arena.

To briefly summarize what was his theory all about, we need to assume that the markets are efficient. The efficient market hypothesis essentially assumes a lot of things that do not make sense but academics love them anyway. Just to mention a few, efficient market assumes that all investors are rational (well if you think monkeys are rational), zero transaction cost (hmmm if sell-side analysts are monkeys and work for bananas) and that information flows freely (monkeys talk to one another all the time and need not buy one another bananas for info) etc. These we all know are not true.

However, that is not the point, the point is once we assume markets are efficient, according to Markowitz the only way we can make more money is to

1) To take more risk (by investing in riskier assets)
2) To diversify (by investing into different asset classes which are not correlated)

This is graphically represented above in what is known as the Efficient Frontier. The Efficient Frontier represents the maximum return that can be achieved at a specific level of risk. If an investor wants to achieve a higher rate of return, she can invest in riskier assets, like equities or venture capital (This is the "Higher Risk, Higher Return" part). This can be easily visualized as shifting from one point (e.g. Bonds) to another point (e.g. Equities) on the right of the same Efficient Frontier.

Now she can also choose to invest in many different kinds of assets (commodities, real estate etc), hence not putting all the eggs in one basket. This will push out the Efficient Frontier (a parallel shift of the whole Efficient Frontier upwards), enabling the investor to reap more return for any given level of risk.

So as I said, elegant math that explained two truths about investment.

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