Can I Spread the Risk for better Returns? Portfolio Theory

The most common phrase uttered when someone wants to invest in the stock market is one of ‘how can I get high returns guaranteed with low risk?’ (I could probably find a top Google search with something similar). To be honest, I have probably searched this myself before attending sessions on Efficient Market Hypotheses (EMH), learning about such things as ‘random walks’ and that investors irrational behaviour makes stocks difficult to predict for even seasoned investors never mind the average Joe.  


Those who (apparently) have….

Some new investors think that there is a way to have guaranteed returns after they see such people as Warren Buffett get a compounded annual rate of 19.7% from 1965-2012 (luck or skill?) or Bill Miller beating the market for 15 consecutive years, which is something we as investors could only wish for.

Some ways to hopefully get a better return….

Those famous words ‘Don’t put all your eggs in one basket’ (who doesn't love a cliché) could actually be the way to mitigate losses in your investment portfolio and come out with a not so bad return (well, you hope more than the risk free return rate of 1.44% (based on UK 10yr Gilt 9/2/16)). Spreading your portfolio will help in reducing your risk of putting all your money in one industry. If you had your entire portfolio in the banking sector (e.g. Barclays) when it collapsed in 2008, you may have seen up to a 40% loss. However, if you had part of your portfolio in banking and some in say, gold, then you would have been able to mitigate you loss and come out with a ‘zero sum’ at worst (the win may cancel out the loss, but at least you didn’t lose which is good, right?). I think sensible people don't invest all of their money in shares anyways, even Markowitz (the creator of modern portfolio theory) said that he puts at least 50% in 'safer' bonds.

An interesting article appeared on the FT (link here) about China and how their reliance on Saudi Arabian oil could lead them to become vulnerable to any instability and other factors in that region. The quote that really sums up what I am trying to explain with portfolio theory above and ‘not putting all your eggs in one basket’ is “it’s all about diversifying risk. It’s less about picking winners and more about modern portfolio”.

Correlation is key when trying to spread your portfolio, you do not want to invest in an industry that can be effected by another one as it will mean your return may increase in one, then decrease in another ('zero-sum'). Let me give you an example:

• The Oil and Airline industry are quite closely correlated (planes use oil; therefore airlines are heavily reliant on the oil price). Between August 2014 and January 2015 the oil price went from $97.27 to $48.36 (a considerable drop), however, American Airlines share price in the same period went from $30.78 to $55.69 (there may be other reasons of course). What I am trying to say with this example is that if you had an oil company investment that would have gone down, but an airline investment would have gone up (probably giving you a low return as the decrease cancels out the increase).

As a final note, I believe the world is more unstable now than ever before so there is a low probability of being able to predict or beat the market, but diversification of your investment portfolio will at least help mitigate losses in my eyes.