This is the first video in a series talking about Portfolio Theory!
VIDEO SUMMARY
In this video we are going to talk about Portfolio Theory. This is one of the areas of Finance where you can really see the magic happen. What it does is use a mathematical formula to show you how financial decision-making can make you money. That is pretty cool so let us jump right into it.
What is Portfolio Theory? Portfolio Theory is based on a paper that was written by Harry Markowitz in 1952. What this paper does is it lays out a very basic concept. The concept is that multiple investments are better than one investment. This is the basis for what we have come to know today as diversification. Diversification is holding in your investment portfolio different asset allocation segments. Well this idea of diversification is based on an equation published by Harry Markowitz. So I am going to put up the equation so you can take a look at it. The math here gets pretty complicated. But I want to focus on this core concept because I think the core concept is very simple and very powerful.
When you are putting together your investment portfolio, you have unlimited options. One of those options is to buy just one investment. Let us say you go out and you buy just one stock. Well that means you are taking all your savings, all your investment dollars and putting it in one particular investment. Now the price of that investment is going to fluctuate. Market prices go up and they go down. And your savings is going to go up and it will go down with this one investment. Now let us say you went out and got a second investment. Let us say you go out and buy a second stock. So now your investment portfolio consists of these two different investment opportunities and both of them are going to be experiencing fluctuations. Sometimes they will go up, and sometimes they will go down. What happens is when you have multiple investments, these fluctuations tend to offset each other. So if you have one stock where you lose a lot of money and you have another stock where you have gained some money, those differences will offset each other. So these big fluctuations that you would have experienced only owning one investment opportunity, those fluctuations get reduced and therefore your risk gets reduced.
Risk is something we care a lot about in Finance because, as we have discussed before, the higher the risk, the higher the reward. This is a way, by just making decisions to construct your portfolio in a smart way, where you can lower the risk without lowering the price you pay for these individual securities. So this is basically explaining the phrase “Don’t put all your eggs in one basket.” That is what this means. We do not want to put all of our money in just one investment opportunity because, if we have a portfolio with different opportunities, we can lower the risk through diversification.
There is a famous economic example that illustrates this that I want to talk through. Imagine there are two businesses on a beach, and one of the businesses sells umbrellas and the other business sells bicycles. Well both of these businesses are heavily influenced by the weather. So during rainy days, the business selling umbrellas is going to make a lot of money. But they will not make any money on sunny days, because no one wants to buy an umbrella. The other business that sells bicycles is going to make a lot of money on sunny days, but will not make any money on rainy days. So you have businesses where the revenues and the profits are going to fluctuate a lot based on the weather. But if you take these two businesses and combine them together, so you sell both umbrellas and bicycles, then all of a sudden those revenues of the fluctuations you are experiencing remain flat throughout the year, no matter whether it is rainy or it is sunny. So you can see that when you put these together using diversification, the character of this portfolio is less risky even though the characteristics of these individual entities did not change. Together they are worth more and because if you went out and purchased these businesses by themselves, the market price that people are willing to buy these businesses is going to reflect the risk of that business. So if I look at the business that sells bicycles, it is going to be highly affected by the weather. It is going to be a high level of risk because of the uncertainty of those revenue streams. So people are going to discount that and we are going to pay a low price for that business. So if you buy the bicycle business at a low price, and you are going to buy the umbrella business at a low price, you can combine them in this portfolio. You reduce the level of risk and therefore, for this portfolio, people in the market are going to pay a higher price. So you just created value there, and if you were to go out and sell this combined portfolio, you can sell it for a higher price.
So that is what I mean when I say smart financial decisions in managing your portfolio can create value. It is because this mathematical equation in Portfolio Theory. Now there is a lot of nuance to this and I want to talk more about what diversification really means. So in the next video, we are going to dig a little bit deeper into the financial equations.