In this world, the winner is the one who chooses the best strategy of behavior. This applies to all areas of life. Including investment. But how can one choose the best strategy of behavior here? There is no single answer to this. However, there are several techniques that increase the chances of a successful operation. One of them is the Markowitz portfolio theory.
general information
This approach is perhaps the most common. It should be noted that the Harry Markowitz theory presented in the article is designed for people with experience or at least minimal theoretical knowledge in the field of portfolio management. First, some general information. The Markowitz portfolio theory is a systems approach that is based on an analysis of expected averages. This technique is used for the optimal selection of assets with subsequent acquisition in accordance with the established risk / return criterion. The theory also involves a detailed analysis of variations of random variables. It should be noted that it was developed in the middle of the last century, and since then it has been the basis for portfolio modeling.
What is its essence?
Markowitz’s theory is based on the statement that it is necessary to minimize the possible risk of a drawdown in a deposit. For this, the optimal asset portfolio is calculated. The yield vector and covariance matrix are also used. But the main feature of this approach is the probabilistic formalization of the concepts of "profitability" and "risk" proposed by Markowitz. So, in particular, the probability distribution is used for this. The expected level of return, specifically for the portfolio, is considered as the average value of the distribution of profits. And risk is the standard deviation of this value in mathematical terms. Moreover, all these indicators can be calculated both for the entire portfolio, and for its individual elements. Moreover, as a criterion of a possible deviation for profitability, the condition for a recession or recovery of the economy is taken.
Let's look at an example ...
Making an optimal investment portfolio is not an easy task. To consolidate the material already written, let's look at a small example. Suppose a certain company, Sunflower, issued shares worth one hundred rubles each. We have a joint stock investment fund. It is planned that this asset will remain in the portfolio for one year. In this case, the stock yield can be estimated as the sum of two components, namely, the growth in the value of securities and dividends. Suppose that the mathematical expectation (average) of an increase in the price of stocks over the past two years was ten percent. And for dividends, the amount of payments per share is four percent. And the expected return is 14% per annum.
What if there are deviations?
First, let's look at the table, and then there will be explanations for it.
Economic conjuncture | Expected Return | Probability |
Rise | 42% | 0.2 |
Neutral | 14% | 0.6 |
Recession | -6% | 0.2 |
So what does this mean? What prospects await our investment portfolio? This table considers the option of economic recovery, maintaining the current situation and recession. The previously calculated values consider a situation where nothing changes qualitatively. At the same time, there is a probability (twenty percent) that the acquisition of shares in Sunflower will bring an annual return of 42%. This is if there will be an increase in economic activity. If a recession occurs, a loss of six percent is expected. Then we need to calculate the expected return. For this, the following formula is used: E (r) = 0.42 * 0.2 + 0.14 * 0.6 + (- 0.06) * 0.2. It is intuitive, and problems with its adaptation should not arise. The result of the calculation is the index. If for risk-free assets its value will be zero (a similar situation is observed for treasury bonds with a fixed coupon), then for all the others the deviation will be much stronger.
We continue to consider an example
Someone may already think that this example is not so small, but believe me, when you have to act in real conditions, you will remember the company "Sunflower" with kindness and affection. So, our joint-stock investment fund, according to Markowitz’s proposals, proposes to diversify the portfolio so that it includes the least correlated assets in terms of risk / return. This will reduce the overall standard deviation, optimizing the overall indicator. For example, the portfolio includes agricultural enterprises and companies that produce sunflower oil. These enterprises are correlated according to one principle - the price of culture. How? If sunflowers rise in price, the shares of agricultural enterprises are growing, and oil producers are falling. And vice versa. Investing in these objects will essentially be a transfusion from one pitcher to the second. Thus, the Markowitz theory is based on two key principles: the optimal ratio of risk / return indicators and the minimum correlation of assets.
Weak spots
Alas, it cannot be said that Markowitz’s portfolio is perfect. Minimum risk for investment can be achieved, but with certain reservations. And to fully study the topic, you need to talk not only about strengths, but also about weaknesses. First of all, it is necessary to note that if the market is growing, then Markowitz’s theory can significantly simplify the process of activity and achievement of tasks for investors. But problems appear when it unfolds. In such cases, investment management, built on the principle of "buy and hold," turns into an increase in losses. It is also necessary to mention the specifics of the mathematical expectation, and, even more specifically, the chosen time interval. The larger it is, the slower the reaction to the emergence of a new series of values.
What other disadvantages are there?
The fact is that the Markowitz theory does not provide tools for determining entry / exit points from a transaction. Because of this, the portfolio has to be counted very often and excluded fall leaders from it. It should also be noted that the existence of a ban on short transactions means that a falling market has its own specific assessment points. For example, the concept of an effective portfolio in such cases often loses its meaning. Another problem: the specific behavior of specific tools in the past does not guarantee the presence of the same in the future. Therefore, gradually, as a substitute for the Markowitz theory, active or combined strategies gain popularity. In them, portfolio theory interacts with technical analysis, allows you to more quickly respond to market changes.
A few management points
Each investor who decides where to direct the available funds must understand a large number of issues. Depending on the field of activity and goals, one should study the forecast of market dynamics, macroeconomic indicators, evaluate their impact on individual assets and portfolios. At the same time, it is necessary to maximize profitability while maintaining an acceptable level of risk. Investment management also requires that the following questions be answered:
- What should I pay attention to - the risk of individual assets or the entire portfolio that is formed from them?
- How to quantify potential hazards?
- Is it possible to reduce the risk of a portfolio by changing the weight of assets in it?
- If so, how can this be achieved by maintaining or even increasing portfolio returns?
A few words about diversification
As previously mentioned, this plays a big role. A special point in this case is that risk must be considered as a property of the entire portfolio, rather than individual assets. Remember, the correlation between different assets was mentioned earlier? If we imagine that we have invested half of the money in growing sunflowers and the same amount in the production of oil from them, then any movement in this market, simply put, will be a zero-sum game. Therefore, there must be no direct links between different assets, as well as the risk of not individual assets, but of the entire portfolio. And yet, for example, certain securities were sold and others were acquired. Thus, a new portfolio is formed, ideally, optimal at a given time. But during the acquisition of new assets, the question arises of their optimal ratio. If there are a lot of them, then solving this problem becomes problematic and requires significant computing power. It is difficult to name a specific approach here, which is universal and applicable in any situation. You can act in an extensive way, simply increasing capacity. As another option, it is to develop a more advanced technology for solving the problem.
What conclusions can be drawn from this
It should be remembered that any theory benefits only practitioners, and only those who are clearly aware of all the features of its application. So let's summarize all of the above:
- A mathematical apparatus has been developed that can significantly facilitate the process of forming an investment portfolio. But at the same time, it requires certain knowledge, without which all the tools cost nothing. For example, a variation of a random variable. What should she be like? What to take as fundamental data? In addition, it should also be noted that the Markowitz theory allows you to visually provide information.
- It should be remembered that this technique is based on the background and does not use forecast methods. Therefore, the theory is ineffective during a general market fall. Nor does it provide entry / exit criteria.
- Despite the fact that a lot of time has passed since the formation of the Markowitz theory, and many serious scientific methods of analysis have already appeared, it is still widely used. But now it’s more as part of mathematical tools.
Whether or not to use this theory is up to you. The main thing is to responsibly approach calculations and forecasting.