Stock Market Financial Theory

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Throughout the recent years, the stock market and financial industry has become a very viable institution in that many people have lost their faith in the stability and the industry’s basic abilities to function due to the economic recession and the threat of further downturn. When dealing with the stock market, it is imperative to have an influx of investors, otherwise, the stock market essentially is not able to stay afloat. In today’s society, many people who are able to invest seem to be doing so with caution and are not as free and risk-averse with their money and investments as they were in a more prosperous time for the economy and for the market. An important aspect for the stock market industry is portfolio theory, which attempts to maximize the return on an investment for any given risk, or on the same token is able to minimize the risk for an expected return on investment amounts. 

The portfolio states that this is made possible by choosing various assets in which you are investing, very carefully. According to Portfolio Calculations (2008) “To determine the expected return on a portfolio, the weighted average expected return of the assets that compromise the portfolio is taken. E(R) of a portfolio = w1R1 + w2R2+ …+wnRn” (p. 1).  This formula is what investors and brokers use in order to figure out the expected return on a portfolio investment. This formula is imperative for everyone involved in the industry, both broker and client alike. If the formula is not used properly, then the brokers, in turn, are not able to accurately do their jobs. If they are not representing the way that the market is performing and the way that their clients should expect their portfolio investments to pan out, in the most accurate way, then they are not able to retain and keep clients. If a client is not able to accurately receive information derived from the portfolio calculations, they will, in fact, take their business elsewhere. If a client is losing money on their portfolio investments, especially a substantial amount of money for a long period of time, this is almost a guarantee that they will leave their current broker and never look back. Money and investments are a precious commodity and should not be taken lightly. There are reasons why these equations exist, and this one does so because of the amount of uncertainty that already exists in the stock market industry and this is somewhat of a cushion for brokers to use in order to try and mitigate the risks that are ultimately involved in every last investment in the market today. 

In terms of the portfolio theory and the idea behind the inclusion of this formula and theory into the modern day world of investments and the stock market hasn’t been around forever. According to Baker (2013) “Prior to 1950, there was no systematic method for portfolio selection and corresponding risk management. But according to Baker, it was to Dr. Markowitz who provided the framework, a theory that has guided institutional investors for decades (p. 1). Dr. Markowitz was the man behind the portfolio theory, who believed it was important that this industry had a formula to sort of live their lives by when doing their lives work. 

Before this time, nothing in terms of theories or formulas were used when it came to the stock market, as it was simply viewed as a volatile industry that always involved risk, no matter how much or little. According to Baker (2013) “What's significant about Modern Portfolio Theory is what it provides: a mathematically-based approach for managing and mitigating risk. Or, in Dr. Markowitz's own words, "a standard process that seems to be used almost universally" (p. 1). What makes this theory relevant is the idea that a majority of people in the financial services and stock market industry has since adopted it and use it on a regular basis. When everyone in an industry is on the same playing field, this leaves less room for errors. It is evident that this theory has grown into something everyone in the industry is well aware of and has used rather frequently when dealing with their work on portfolio investments.

Dr. Markowitz was able to take a problem, the idea that no theories or formulas were available to relate to the stock market, and turn it into a solution, thus the creation of the portfolio theory and formula. According to Levine (2011) “For over six decades, “MPT,” as Modern Portfolio Theory is nicknamed, has provided money managers and sophisticated investors with a tried-and-true way to select portfolios” (p. 1). Since it’s inception, the theory has stood the test of time and has gone through the Great Recession of 2008 as well as the recovering economy and very volatile stock market since then. According to Levine (2011) 

Markowitz’s work is the key to squeezing the best returns with the least amount of risk out of portfolios of different asset classes. It analyzes the effects of asset risk, correlation and diversification on expected portfolio returns. But much depends upon how you split up your investment pie, Markowitz stresses (p. 1). Being able to properly use the portfolio theory puts a broker ten steps in the right direction in terms of figuring out the gains their clients may be able to make regarding their portfolio investments. Again, any type of investing you choose to partake in will involve risks. This theory was formed in order for people in the industry to help their clients, as well as themselves and others in the industry, learn how to make those risks less risky. If they are helping their clients win, these clients may continue to invest more financial resources with their broker. The more money invested, the chances are, the better the stock market will continue to do. If the stock market is healthy, this, in turn, helps out the economy as well. With a healthy economy and approval from the securities and exchange commission, society is slowly working its way back to a prosperous nation, like they were before the Great Recession in 2008. According to Levine (2011) 

Markowitz said investors should estimate the likely returns, risks and correlations among various asset classes and use these inputs to conduct a Modern Portfolio Theory analysis. This produces a curve of “efficient” risk-return combinations. If you want greater return on average, you have to take on greater risk. If you want less month-to-month and year-to-year fluctuations, you have to accept less return on the average in the long run (p. 1).

By being able to be strategic in the approach you take while setting up a client’s portfolio of investments, you are able to mitigate risks and get them more for their investments. Overall, many investing clients are well aware that if they want to potentially receive more money, they are embarking upon greater risks of losing their investments as well. If they are interested in the long term return on their investments and a slow and steady increase, the risk with those types of portfolio investments is much smaller.

Beginning investors may believe that investing in one stock is a safe way to hopefully grow their investments and make the most money, however, this assumption couldn’t be further from the truth. By using a portfolio investment, or by investing your assets in numerous stocks, compiling a portfolio, you are giving yourself a better chance of reaping more rewards than if you were to put all of your eggs in one basket if you will. This is called diversification. According to McClure (2006) 

Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio (p. 1).

Clients who are new to the investment realm are able to slowly ease themselves into the investing world, especially if they are not financially ready to invest in riskier companies.  With the option of creating a portfolio, these clients are almost always able to collect on some of their investments. This will keep new clients from shying away from the investment world altogether. Many people are afraid of investing money into the stock market, especially now during such a volatile time, as the economy is still not fully recovered from the Great Recession. For more esteemed investors, portfolios may be something they are interested in as well because they are better versed on how the market works and may be more interested in the continual growth of their accounts, as opposed to the riskier one account investment.

There are two types of risks associated with investment: systematic risks and unsystematic risks. According to McClure (2006), a systematic risk “cannot be diversified away.” Unsystematic risks “is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio” (p. 1). In a portfolio investment, investors are able to benefit the most because their risks are very diversified. There are numerous options when it comes to compiling a portfolio for investors; therefore there are also numerous levels of risks involved, which can adapt to whatever the investor is comfortable with. It is important for clients to understand that brokers are now able to tailor portfolios to meet every individual's needs and wants when it comes to investing, and not everything is a one size fits all option.

In terms of real-world scenarios involving the portfolio theory, it isn’t as always as cut and dry as reducing risk for the investor. According to McClure (2006) “Sometimes it demands that the investor take on a perceived risky investment in order to reduce overall risk” (p. 1). By doing this, new investors may need a little bit of education from the broker as to why this step may be necessary for their portfolio investments. An investor who is wary about investing their assets in the beginning usually does not want to hear about how an investment may potentially be a risky move, but with a little assurance as to why the broker is making the moves in their portfolio that they are, they should be able to ease the fears of their client. Some people may believe that the portfolio theory basically assumes that investments are individual investments and are not interrelated to other investments involved in the portfolio; this is also not the case. According to McClure (2006) “Market historians have shown that there are no such instruments; in times of market stress, seemingly independent investments do, in fact, act as though they are related” (p. 1). The market moves in unison with the trends of the economy. Often times, stocks that make up a portfolio may be similar in nature, therefore, they will somehow be connected with each other. 

Regardless of the number of stocks a client and their broker decide to put into a portfolio, they are still unable to remove all risks involved altogether. The stock market is an unpredictable machine. According to McClure (2006) “The gist of MPT is that the market is hard to beat and that the people who beat the market are those who take above-average risk. It is also implied that these risk takers will get their comeuppance when markets turn down” (p. 1). The entire system is all about the amount of money you have, how educated you are on the way the stock market works and just exactly how much risk you are willing to take in order to hopefully reap the rewards should you be able to work the market in your favor. The more educated an investor comes on the different types of stocks that are available, especially when investing in a portfolio, the better their outcome will be, especially in the long run as their investments start to grow. While all investing can prove to be risky, by using the portfolio theory and formula to make better choices when it comes to your investments, perhaps more people will become involved in investing in the stock market, once they are aware of the many different options available to be tailored to their individual needs.

References

Baker, D., & Markowitz, H. M. (2013, November). Dr Harry Markowitz and the birth of modern portfolio theory. Retrieved from https://www.bnymellon.com/us/en/our-thinking/dr-harry-markowitz-and-the-birth-of-modern-portfolio-theory.jsp

Levine, A. (2011, December 28). Harry Markowitz - father of modern portfolio theory - still diversified. Retrieved from http://post.nyssa.org/nyssa-news/2011/12/harry-markowitz- father-of-modern-portfolio-theory-still-diversified.html

McClure, B. (2006, February 14). Modern portfolio theory: Why it's still hip. Retrieved from http://www.investopedia.com/articles/06/mpt.asp

Portfolio Calculations - CFA Level 1 | Investopedia. (2008, April 18). Retrieved from http://www.investopedia.com/exam-guide/cfa-level-1/portfolio-management/portfolio-calculations.asp