2. Portfolio Theory Overview

2.1. Introduction

Advances in portfolio theory are creating new investment opportunities for retail customers. Here we review the key ideas of modern portfolio theory and their effect on the retail investment industry. It concludes by showing how practitioners can incorporate modern ideas of investment management into client portfolios and thus produces portfolios consistent with current investment knowledge. Before 1952, investment managers focused mainly on the selection of individual securities. Stocks deemed safe were allocated to widows and children while riskier stocks were reserved for wealthier investors, assumed to be capable of bearing greater uncertainty. There were no sophisticated measures of portfolio performance, and investment services were sold mainly on the strength of client relationships.

2.2 Harry Markowitz Model

That began to change in early 1952, when economist Harry Markowitz introduced a revolutionary concept: the risk of a portfolio depends not on the individual risk of each investment, but on how all securities in the portfolio behave together. Markowitz's ideas earned him a Nobel Prize and made obsolete the old approach of "buy blue chip stocks for conservative clients." His ideas created a new goal of money management: the construction of portfolios that produce the highest expected return for a desired level of risk. With this theoretical advance came the idea that even widows and orphans should have some volatile securities in their portfolios. Diversification--the idea of assembling a variety of assets that perform differently from each other instead of a portfolio of similar performing investments--became the essence of portfolio construction. This concept caused problems for practitioners. Who could sort through all the possible combinations of assets to find the portfolios with the highest expected return for each level of risk?

2.3 William Sharpe Model

In the early l960s, William Sharpe came to their aid. His idea, leading to another Nobel Prize, identified the stock market in toto as the most efficient equity portfolio. According to Sharpe's Capital Asset Pricing model, no other combination of stocks can offer an expected return higher than the market's return at that particular market level of risk.(2) He argued that if there was a portfolio of securities offering a return higher than the market at only a market level of risk, then the natural forces of supply and demand would force the price of those securities hack in line. Sharpe concluded that the optimal way to construct a portfolio is to choose an appropriate level of risk,. invest in the market portfolio to the extent of this risk-bearing ability, and then invest the remaining funds in low-risk assets such as Treasury bills. This was a major assault on the idea that investors could consistently beat the market by picking winning stocks. Sharpe's model suggests that the market is efficient and that the research-gathering and extra transaction costs incurred why stock-picking activities cannot be expected to yield superior investment performance. According to this view, a stock's price quickly reflects all known information about its value. Only unanticipated information would cause the stock to deviate from its expected performance. Obviously, such unanticipated information frequently occurs, but it occurs randomly and is equally likely to he negative or positive. As a result. an investor cannot predict future price changes, and thus cannot reliably discern winning stocks in advance.

2.4 Other Ideas


In the 1980s, index funds became available to the retail market, either directly to consumers or through the inclusion of index funds in 401(k) options for employees. They are widely available to individual investors at low-cost for many market sectors. including small and large capitalization, and domestic and international securities. While retail index funds comprise less than three percent of the market, index funds and their market share are growing. The percentage of equity assets in index funds in the Morningstar database rose nine-fold in the last decade, from 0.23 in 1983 to 2.08 in 1993. The flagship Vanguard S&P 500 index fund has grown from a starting base of zero in the mid-1970s to its current rank as the 10th largest fund in the Morningstar datahase.(7) This trickling down of academic notions of portfolio excellence is also seen in the proliferation of asset-allocation products. In a widely quoted academic study. Brinson, Hood, and Beebower show that the major determinant of the variation in a portfolio's return stems from the sole decision of how to divide funds among the various classes of assets: cash, bonds, and stocks.8 This is in keeping with the already cited academic theories suggesting that the benefit of focusing on the mixture of securities, not on the individual securities, for optimal portfolio construction, and on the notion that choosing a portfolio level of risk is the first step in constructing a sound portfolio. These academic ideas, along with a desire on the part of consumers for simplification, are the rationale behind these asset-allocation products. Another example of academic theory washing over into the real world is the recent introduction of the Prudent Investor Rule.(9) This change in trust law incorporates modern ideas of portfolio theory into a new standard to which trustees are held accountable. This standard requires that trustees ensure that assets are well diversified and that the risk of the portfolio matches the risk of the beneficiary. including risk of loss of principal and of loss of purchasing power. This new standard for fiduciaries will be a potent tool for persons trying to promote change in a personal trust.

 

2.5 The Impact of Technology on Portfolio Theory

Putting the ideas of asset-class investing into practice requires sophisticated use of technology. Advances in computer technology are transforming the world of investment management, and in particular, trading methods. For example, index funds can reduce transaction costs by processing large block trades through off-exchange, matching networks, often at a fraction of the cost levied by the more traditional exchanges. In more illiquid markets, such as the small stock area, a trade's market impact often is the most important portion of total transaction cost. Portfolio managers can reduce these costs by bidding for large blocks of stock at discount prices. A good example of these trends is the trading desk at Dimensional Fund Advisors (DFA), a leading asset-class investment manager. At DFA., portfolio managers sit in front of several computers loaded with huge databases of financial information and showing real-time quotes in several markets. By refining their use of these databases and positioning themselves as a major block trading house, DFA has been able to reduce trading costs to virtually zero, even in the highly illiquid area of small capitalization stocks. Index funds have very low costs because they use sophisticated trading strategies and because they do not pay the high cost of gathering "predictive". information about individual securities. Operating expenses for actively managed equity mutual funds often exceed 1.00 percent a year. while comparable costs for index funds range from 0.20 percent for major market indexes to about 0.65 percent for the more specialized niches like small stocks or international stocks.

 

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