Saturday, February 6, 2010
Thoughts on Portfolio Selection - Earl Malvar
Portfolio diversification is indeed an indispensable component in investment and portfolio management. As common sense would have it, investing entails maximizing return and minimizing risk and here lies the theory that there exists a desirable set of portfolios or efficient frontier that follows the E-V Maxim, as described by Harry Markowitz. Although the author attempts to make a demarcation between the activities of investing and speculating, I am prompted to believe that both are synonymous in essence. Mr. Markowitz’s intent to explain may have been lost in translation or in the evolution of the word “speculate” through the years, but I feel that his theory should instead be referred to as a delineation between investing and gambling. In this article, he was explicit about focusing on investor behavior in portfolio selection and had yet to explore his “first stage”: the formation of the relevant beliefs on the basis of observation. His second stage on portfolio selection is anchored on the expectations of securities performance. He offered some suggestions on how the values of expected returns and risk could be obtained via statistical methods. And here lies a microcosm, in my opinion, of the “human struggle” in the field of financial investments. I think that predicting the future or simply the next day’s outcome is always anybody’s best guess. It will always be an unknown and statistical tools can only reveal so much. I do agree with his belief that statistics should be combined with the judgment of practical men. Statistics and its various methodologies allow the assembly of models based on variable relationships, probability, mean regression and other assumptions that give investors a degree of confidence in decision making. The fact that the field of finance is populated by trained, experienced and like-minded professionals who are educated in the ways of the commerce of man brings about a sort of structure/order that may influence market logic, expectations and reactions. The regard of investors in the dynamism of the market is but a reflection of how professionals in the field of finance attempt to predict or derive a truth of a probable future. Despite the uncertainty in the future performance of a portfolio, the very practice of diversification, in all its intent and rationale, points to the objective of reducing the risk of loss, while aiming to enhance the original investment. Mr. Markowitz’s E-V hypothesis in itself presents a logical rule on investing in an optimal portfolio. Taking into regard interrelationships among securities, as reflected by correlation and covariance, highlights the value of diversification by “not putting one’s precious eggs in one carton box.” Diversification ensures that exposure to risk is kept to a minimum, especially when taking into account how a portfolio’s contents interact amongst themselves. The E-V Maxim, however, only shows the “best” set of securities to put money on, but is unable to highlight the varying degrees of investor risk tolerance. The most desirable portfolio may not necessarily depend on quantified risk and return because these are but suggestive and assumed numbers to a unique-minded investor.