It has been seen in most of the
countries that ‘stock’ investment outperforms all the other investment options.
Then why do people invest elsewhere? The answer is ‘risk’. Stocks’ price
changes every now and then. They have daily ups and downs.
Markowitz has given the idea
regarding what is the best investment? What one ought to do as a portfolio
manager? Given that one is inclined with numbers and can find out average
returns, variances, co variances etc. let’s say there is only two investment
options available. 1. Stocks (high returns, much riskier) 2. Government bonds
(fixed returns, much safer).
Now if I have 100$ which I invest
in stocks (e.g. 20% return with 40% standard deviation) if I borrow another
100$ (a debt, 5% interest rate) to invest in the stocks, what would be the
expected return then? Ans. 35%. (Because on my investment of 200$, I would get
40$ but I have to pay 5$ interest to my lender). Another way is, I go to the
broker and say I want to sell stocks, I don’t own any. Broker offers me 200
shares. If I sell them, that 200$ will be received by broker. And he will pay
me 5% interest on that. So now I wouldn't be getting 40$. I will be receiving
10$(5% on 200 shares) plus 5$(interest on my capital, 100$) total -25$
(15$-40$). These were the two extreme cases. Similarly, in this way I can have
multiple alternatives of investments. I can get any return I want with the help
of leverage. Then what is the optimal portfolio?
The crux of the Markowitz’s theory
was, there is no best investment. There’s only a trade off between risk and
return. All we need to do is thinking of the best trade off. Higher the risk is,
higher the return would be. And vice versa.
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Image courtsey: coursera.com
*[standard deviation represents risk factor]
As an investor we
have multiple options. If we choose to be a 100% stock investor, we would be
having greater risk involved. Similarly, if we put our 100% money in bonds then
it would be less riskier. This graph shows us that why we should not be a 100%
bond investor. As we can see that at 10% SD level, we would get 9% return. But
if we invest 50-50% in each of the investment options, we would get 11%
interest at the same SD level. So one should never be a 100% bond investor.
This was a
revolutionary idea. as before 1952,
nobody thought like what Markowitz did.
[Mr. Harry Markowitz is a Nobel
Prize winner for his contribution in economics]
Basic terminologies:
- Leverage: investing with borrowed money as a way to amplify potential gains.
- Stocks: the capital raised by a corporation through the issue of shares entitling holders to an ownership interest (equity).
- Portfolio: A group of investments.
