CENTRAL CONCEPTS OF MARKOWITZS MODERN PORTFOLIO THEORY
In 1952, Harry Markowitz presented an essay on Modern Portfolio Theory for which he also received a Noble Price in Economics. His findings greatly changed theasset managementindustry, and his theory is still considered as cutting edge in portfolio management.
There are two main concepts in Modern Portfolio Theory, which are;
Any investors goal is to maximize Return for any level of Risk
Risk can be reduced by creating a diversified portfolio of unrelated assets
Other names for this approach arePassive Investment Approachbecause you build the right risk to return portfolio for broad asset with a substantial value and then you behave passive and wait as it growth.
Lets briefly define Return and Risk.Return is considered to be the price appreciation of any asset, as in stock price, and also any Capital inflows, such as dividends.
In general Standard Deviation is a fair measure of risk as we want a steady increase and not big swings which might possibly end up as loss.
Risk is evaluated as the range by which the assets price will on average vary, known as Standard Deviation. If an assets price has 10% Deviation from the mean and an average expected Return of 8% you may observe Returns between -2% and 18%.
In a practical application ofMarkowitz Portfolio Theory,lets assume there are two portfolios of assets both with an average return of 10%, Portfolio A has a risk or standard deviation of 8% and Portfolio B has a risk of 12%. As both portfolios have the same expected return, any investor will choose to invest in portfolio A as it has the same expected earnings as portfolio B but with less risk.
It is important to understand risk; it is a necessary concept, as there would be no expected reward without it. Investors are compensated for bearing risk and, in theory,the higher the Risk, the higher the Return.
Going back to our example above it may be tempting to presume that Portfolio B is more attractive than Portfolio A. As portfolio B has a higher risk at 12%, it may obtain a return of 22%, which is possible but it may also witness a return of -2%. All things being equal it is still preferable to hold the portfolio that has an expected range of returns between +2% and +18%, as it is more likely to help you reach your goals.
Risk, as we have seen above, is a welcomed factor when investing as it allows us to reap rewards for taking on the possibility of adverse outcomes. Modern Portfolio Theory, however, shows that amixture of diverse assets will significantly reduce the overall risk of a portfolio.Risk, therefore, has to be seen as a cumulative factor for the portfolio as a whole and not as a simple addition of single risks.
Assets that are unrelated will also have unrelated risk;this concept is defined as correlation. If two assets are very similar, then their prices will move in a very similar pattern. TwoETFsfrom the same economic sector and same industry are likely to be affected by the same macroeconomic factors. That is to say, their prices will move in the same direction for any given event or factor. However, two ETFs (Exchange Traded Funds) from different sectors and industries are highly unlikely to be affected by the same factors.
Thislack of correlation is what helps a diversified portfolio of assets have a lower total risk,measured by standard deviation than the simple sum of the risks of each asset. Without going into any detail, a bit of math might help to explain why.
Correlation is measured on a scale of -1 to +1, where +1 indicates a total positive correlation, prices will move in the same direction par for par, and -1 indicates the prices of these to stocks will move in opposite directions.
If correlation between all ETF pairs is 1, then it would seem reasonable that the total risk of the portfolio is equal to the sum of the weighted standard deviations of each individual ETF. Whereas a portfolio where the correlation of asset pairs is lower than 1 must lead to a total risk that is lower than the simple sum of the weighted standard deviations.
The magic of building different pairs is that by different combination it is possible to achieve basically every risk to return combination, even different from the risk to return level of the single components.
The concept ofEfficient Frontierwas also introduced by Markowitz and is easier to understand than it sounds. It is agraphical representation of all the possible mixtures of risky assets for an optimal level of Returngiven any level of Risk, as measured by standard deviation.
The chart above shows ahyperbola showing all the outcomes for various portfoliocombinations of risky assets, where Standard Deviation is plotted on the X-axis and Return is plotted on the Y-axis.
The Straight Line (Capital Allocation Line) representsa portfolio of all risky assets and the risk-free asset,which is usually a triple-A rated government bond.
Tangency Portfoliois the point where theportfolio of only risky assets meets the combination of risky and risk-free assets.This portfolio maximizes return for the given level of risk.
Portfolio along the lower part of the hyperbole will have lower return and eventually higher risk. Portfolios to the right will have higher returns but also higher risk.
Markowitz Portfolio Theory(Modern Portfolio Theory or Passive Investment Approach) is the base idea of the Ways2Wealth concept.
Read more in the other articles to understand the Ways2Wealth Investment Approach.
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Most of the existingrobo-advisorcompany founders have their roots in sales or advertising of big banks and offer just some Algos to manage their customers accounts. This is different here as we have a deep knowledge in Algo development.
The Algorithm used to develop the portfolio in Ways2Wealth platform is connected to a high end supercomputer and each portfolio is optimized and developed according to complex formulas on the supercomputer.
Asset management is an efficient process of managing Individuals or Institutionals investments and providing them with thestrategic solutionsthat would allow them to achieve their desired goals and secure their financial future.
Asset management is the process of investment in order to create wealth for future, every individual or institution needs asset management solutions, since it helps them to grow financially over the period.
Asset management is anallocation of investments into stocks, bonds, commoditiesand other type of investments such as real estate, private equities, etc. depending upon the risk profile of investor.
Asset Managers analyses the market and investor requirements, accordingly create an asset management plan depending upon investors risk taking capacity.
Asset management consultants diversify investment into Stocks which can be
Bonds of government or corporate firms for short maturity period or long maturity period;
Commodities such metals, grains, energy etc., and other types of investments such as real estate, infrastructure etc.
How Ways 2 Wealth Online Asset Management Tool Helps You
If you start to develop your portfolio (for example by clicking here:start building asset management portfolio) you will be asked to quantify your risk level on a scale of 1 to 20, by answering 6 basic questions. Ways2Wealth provides you the details of optimal portfolio at your risk level and keeps you updated on the portfolios status on a daily basis.
We have built a comprehensive profile in the login area which provides you all the information about your asset management portfolio. For example, the interactive graphs will show you the entire historic performance of your portfolio, yearly risk assessment depicting the maximum loss and profit incurred through the years and your position on arisk-return profile.
Future projection (based on historic performance) is also made available for the next five years. The investors can freely register to make their portfolios and open an investment account with a broker of their own choice. No fee is charged for provision ofstrategic asset managementportfolio details.
Ways2Wealth provides the asset management services targeted towards European investors. European laws are different then United States or other parts of the world and require a careful handling of investors portfolio. Not using UCITS compliant funds can have negative legal consequences for the investor (we are going to write an article about it and give some examples from different countries).
Ways2Wealth understands the European laws and hence all suggested portfolios and their constituent funds areUCITS compliant.
Exchange Traded Funds(ETFs) selection of Ways2Wealth is actively done from a huge set ofpossible ETFswhere the right ETF are selected from a proprietary selection algorithm combined with a threshold when to bring in a new ETF in an existing portfolio.
The portfolios comprises of thebest performing exchange traded funds (ETFs)tracking the most popular indices. The funds are managed by highly reputed companies includingBlack Rock(ishares) andDeutsche Asset Management(db x-trackers) whereas the choice of brokers is left to the clients.
The funds are shortlisted from a universe of over 4000 instruments based on a variety of parameters including European compliance, trading fee, trading volume/liquidity, mutual correlation, risk level, return profile and so on.
The shortlisted funds are then optimized using sophisticated supervisedmachine learning algorithmsfor each risk tolerance level. The risk-return profile of individual funds and the portfolios can be seen in the following figure.
Figure:The above figure shows theRiskReturn Profileof 12 exchange traded funds and the 20 optimalWays2Wealth Portfolios.
It can be seen that low risk & low return funds are the two European bonds on the bottom left corner whereas high risk-return funds can be found on the top-right side of the figure (e.gMDAX, TecDAXandReal estate funds). There are no naturalin-between solutions comparable to the Ways2Wealth recommendations.
Portfolios are constructed using the optimal combinations of these funds for each risk level. It can also be seen in the figure that all proposed portfolios are at much lower risk levels then the individual equity funds. These lower risk levels are achieved through diversification and optimization.
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In general, the portfolios with lower risk tolerance level are assigned more proportion of lower risk funds (such as bonds) and vice versa. However the exact assignment is subject to numerous optimization parameters. The constituent proportions of each portfolio can be seen in the following figure.
FIGURE:The above figure depicts the area chart for 20 Ways2Wealth portfolios. The X-axis depicts the risk levels whereas the Y-axis shows the percent split of each ETF. A higher area means more proportion in the Portfolio at that risk level. Low risk funds include bonds whereas high risk funds include MDAX, TecDAX, Dow Jones and Real estate ETF.
Low Risk Portfolios v/s High Risk Portfolios:the proportion/percent split (area) of low risk funds is more than the high risk funds. Whereas inthe proportion of high risk funds is more than the low risk funds.
The above figure shows the Portfolio against theDow Jones US Select Dividends. From a profit site the Ways2Wealth Portfolio is comparable to the profit of a single ETF but the risk (see chart below) is much lower than the risk of a single ETF.
You can see the better risk behaviour in the time of late 2015 where the market (Dow Jones) went down while the Ways2Wealth asset management portfolio stays stable.
The portfolios recommended by Ways2Wealth are diversified and optimized using scientific approach. The superiority of our proposed portfolios can be visually seen in the following figure.
A comparison is drawn betweenWays2Wealth diversified portfolio(see the red proposed portfolio) and a single fund. It can be seen that the return of Ways2Wealth portfolio is very much comparable to one of the highest return producing ETF tacking the Dow Jones.
In fact, in after years (e.g. 2014 2015) the portfolio was performing even better than individual fund. But the superiority of Ways2Wealth portfolio is not the comparable return but is rather thehighly reduced risk.
It can be seen in the risk-return comparison figure that the Ways2Wealth portfolio has at much lower risk than the individual constituent funds. Any investor would be happy to invest his money in the portfolio which gives similar profits but have much lower risk levels.
Science can make a difference in trading. Ways2Wealth is a blog made by Scientific Algorithm Developers and not by some sales persons. Use ourfree portfolio toolto develop a better portfolio.
The entire research staff of Ways2Wealth has PhDs in their respective fields. The portfolios are constructed by human experts and are optimized using sophisticated machine learning algorithms.
If you want to build your portfolio you simply have to register to get updates on your portfolio. Our portfolio andAsset Management Toolis free and will stay free forever.
Ways2Wealth is a free and non-commercial blog forasset management. The blog founders have a background asalgorithmic trading and risk strategy developersand decided to give advance trading algorithms to public for free.
When it comes down to choosing what to do with your savings the majority of people will identify the most common securities such as tradingStocks,BondsandMutual Fundsas well as perhapsGold. Of course, theseinvestments optionsinvolve some risk, in that their price can go down as well up. Inevitably there is the possibility that one day you may check your balance and see that it has fallen. However, the possibility of financial loss is offset by the fact that you also have a very high probability of financial gain.
Now, while we may be well aware that thefinancial marketsmay also fall, it is still necessary to understand this risk. Understanding risk helps us decide how to manage it, and will help us build low risk portfolio that overall, have lower levels of risk than any single security for a given level of return. The correct and diligent management in passive investing can create superior returns and prove to be very cost-effective.
Efficient Market Hypothesisstates thatPublic and Liquid Marketssecurity prices fully reflect all available information. This means that trying to beat the market is more a matter of luck than a matter of skill. The hypothesis has three forms; weak, semi-strong and strong.
Weak-Form Efficient Market Hypothesis:The weak form states that neither past price nor volume has any relationship with future price. Therefore Technical Analysis, or using charts, is ineffective.
Semi-Strong Efficient Market Hypothesis:The semi-strong says that stock prices adjust rapidly to available market and non-market information. Therefore, in this case, Fundamental Analysis is not able to produce superior returns.
Strong-Form Efficient Market Hypothesis:The strong form states that price reflects all public and private information. That is, market or non-market, as well as inside information, are all factored into price. Therefore excess returns are not possible to achieve on a consistent basis.
The Efficient Market Hypothesis ties into another concept theRandom Walk Theory. In this latter case, the market is likened to a drunken man walking down the street. At some point, he will swerve to the right and then at another to the left. These swings from right to left are independent of each other; that is to say, what happened in the past cannot help in determining what will happen next. In short, price changes and direction are totally unpredictable.
Both theories have often been challenged by some academics making the claim that these two concepts are incorrect. However, academia has produced many white papers that show how these concepts still apply. And there is a logical reason these ideas would be challenged. There is a Psychology factor; it is human nature to be active, and therefore, to be in control. If we invest passively, then we are not the owners of our destiny. We feel less important and of course, our egos cannot feed themselves on the last greatest stock pick.
Despite the lack of satisfaction that may come frompassive investingit is hard to prove it can be beaten. Many investment managers can show records of various years with relatively decent returns, but it would be extremely difficult to find managers that can display a decade of out-performing returns, let alone a lifetime. Whereas holding investments in the broad Stock Market has consistently out-performed many active managers.
If you were invested in theDow Jones Industrial Stock Market Indexinyear 1900 with $10,000and you stayed the full course, through all the highs and lows, your investment wouldnow be worth $3,313,915. I know that sounds incredible and youre thinking $10,000 was a lot of money back in 1900. Yes, it was, it was worth around $291,000 in todays money. So the market multiplied that by more than 11.
It has been shown thatportfolio diversificationwill significantly reduce the overall risk. Diversification means holding various assets whose returns are not driven by the same factors. This means low or no correlation of returns, which will create a portfolio with a lower risk than the sum of its elements.
Markowitz came up with a model now widely known and accepted, called theModern Portfolio Theory. This theory contends that there are two types of assets;Risky AssetsandRisk-Free Assets. An investor then chooses how much risk to take on by investing more or less in risky assets. This leads to the creation of the efficient frontier, which is a graph showing what return to expect for any given level of risk.
However, formodern portfolio theoryto hold there are various presumptions, one is that the risky portion of the portfolio contains all risky assets. If an investor is invested across all risky assets, then their total risk is only systemic. That is to say, they are not exposed to any single risk factor which may affect an industry or a particular corporation. This improves downside protection of the portfolio; if you are heavily invested in one asset which takes a large loss in price your portfolio is greatly affected. Like the old adage says,Never Put All Your Eggs in One Basket.
Passive Investingin the long term is more likely toproduce positive returnson a consistent basis. Active management which attempts to time the markets and select the best performing stocks may show some out-performance, but are not as likely to be as consistent as the general market.
Credit Suisse Hedge Fund Indexhas had an annual return, net of fees, of 7.96% since inception in January 1994; theS&P 500 Indexhad an annual return of 8.76%. It is also easier to choose the wrong manager when investing in active management, as these managers are trying to beat the market and use strategies that can cause dire results. A passive manager is more concerned aboutportfolio management and analysis, and about constructing an adequate portfolio given the investors needs.
You MAY BE INTERESTED TO read the other articles mentioned below for the full OVERVIEW on passive investing, how you can benefit from it and what we offer in the free portfolio.
The main difference between Active and Passive Fund Management lies in how active and passive investment strategies are implemented.
⦿ Actively managed fund attempts to beat market performance through superior security selection. That is to say;active investments fund manager tries to pick the stock that will perform much better than the market average.
⦿ In other words, thisfund manager is looking to select the winning stocks, as these companies will presumably outperform their peers. There is a theory that allows managers to contemplate stock picking as a viable way of improving a portfolios performance.
⦿ The line of thought rests on the idea that markets are inefficient, andthere are time lapses between data, news or headlinesbeing released and the subsequent change in price needed to reflect the new information.
⦿ Skilful managers, therefore, are capable of taking advantage of market inefficiencies and improve on the broad market performance.
⦿ Passively managed funds track the broad market usually represented by an index. Passive fund managers do not attempt to outperform the market; in general,passive fund managers strive to have a portfolio that best reflects a broad market index.
⦿ The thought behind passive investment strategy is that abroad and well-diversified portfolio greatly reduces the risks involved with stock picking.It also means that passive investment funds portfolio will mimic the returns achievable by the index.
⦿Why does the stock market as a broad asset class creates positive returns?The theory behind this question is that investors need to be rewarded for the risk of holding corporate stock. This security is last in line to be paid out in the case of bankruptcy, pays variable dividends and is subject to various risks.
⦿ However,stocks are also the asset class which best holds the value of a corporation,as the companys value increases so does the value of its shares, in this way investors receive their compensation for holding stocks.
Index Investing ispassive investment strategyto build a broad and well-diversified portfolio which greatly reduces the risks involved with stocks to invest in. Passive investment portfolio will mimic the returns achievable by the index.
ACTIVE FUND MANAGEMENT INVOLVES GREATER RISK, NOT NECESSARILY GREATER REWARD
Withpassive portfolio management, it is therefore not necessary to hold concentrated amounts of a few stocks in an attempt to pick the best performers. There is much more risk and a low chance of actually picking the right stocks.
Imagine a portfolio that holds a broad well-diversified portfolio through a specific number of ETFs, where the total number of different stocks is 200. If one of the companies where to even go completely bankrupt, the total loss for the portfolio would not be more than 0.5%. On the other hand, if a portfolio constructed with only 10 stocks were to see one of its investments fail, it would equal a loss to the portfolio of 10%.
Most actively managedMutual Funds are not allowed to have high concentrations of any particular stock, but picking the wrong stock can have severely adverse effects on the overall performance of the portfolio. The fact that they hold a selection rather than the broader market makes these funds vulnerable to selection risk.
When looking at performance comparison, it has been very hard over the decades to find sustained periods where actively managed funds outperformed its passively managed peers. It is important to understand the concept of sustained positive returns.
Active fund managers that perform well can be found and usually their outperformance occurs during a limited period of time. However,investing in the stock market with index funds involves a long-term investment horizon. Investing should be considered as a marathon rather than a sprint. It is important then to look at long-term results rather than short-term returns of 1 or 2 years.
When comparing performance between passive and active funds the most interesting metric we have is to look at how often active funds performed in comparison to passive funds. If most of the time active funds outperform passive funds it should mean we are going to be better off investing in the former.
Data shows the opposite to be true. The table below shows the percentage of passive and active management funds that outperformed their passive index.
TheLowest Cost column represents passive management funds; they are the funds that charge the lowest fees. TheHighest Cost column represents actively managed fundsas they charge the highest fees.
We can see that over the 10 year period ending December 31, 2014,active funds underperformed compared to passive funds in all categories.In the US Large Value sector, passive funds outperformed their index 66.3% of the time while active funds outperformed only 18.6% of the time. The above table from Morningstar shows howpassive funds are more likely to outperform in all categories as compared of active funds.
Survivorship rates are also much higher for passive funds compared to actively managed funds. The table below shows thatat the end of the 10 year period only 50.22% of active funds were still in business, while for passive funds that rate was 64.91%.
The table also shows that average performance in terms of annualized returns was also higher for passive funds.Annualized performance for passive funds on an asset weighted basis was 0.94% higher over the 10 year period, and passive fund performance also outperformed active fund performance for all other trailing periods measured.
The table also shows thathigher fees do not generate higher returns. Performance by fee quartile was highest for passively managed funds in the 25th percentile; that is to say funds with fees in the lowest quarter.
Although there may be a role for actively managed funds for certain investors, data shows that in the long run,passively managed funds have lower fees, higher survival rates and better chances of outperforming their index.
An ETF, or Exchange Traded Fund, is a basket of different assets that are more or less traded like any other individual stock through some brokerage firm. Exchange Traded Funds are index that work like a stock, devised to match and track the components of a market index. ETF funds can be bought or sold all day long which means that the price of ETF funds continue to change throughout the day. There is no minimum requirement when it comes to buying ETF funds.
Individual investors mostly invest in ETF funds in their portfolio as sole focus, which helps them to build a diversified portfolio. However, most investment fund managers use ETF funds to complement their portfolio and to implement the investment strategies by relying on the ETFs.
In order to benefit from the ETF, it is important to understand them. Fortunately understanding ETF is not extremely difficult thing to do since they are very straightforward.
ETF looks similar to mutual funds and acts like any Stock on the Stock Exchange. The performance of the ETF funds tracks an underlying index. The ETF is basically designed to replicate underlying index.
The ETF provides a broader market exposure along with low operating costs. Another very useful aspect of ETF is low portfolio turnover. As compared to the index funds, the ETFs are mostly much cheaper and they also provide you with ease in terms of taxes.
ETF has gained popularity and recognition in past few decades. However, despite the prominent growth and popularity, questions likewhy to invest in ETFcrosses investors mind every once in a while.
There are a lot of reasons that makes ETF perfect choice for a lot of investors; some of them are as follow:
The price point when compared with index or mutual funds is a biggest plus for the ETF funds. ETF funds do not man-aged the way mutual funds do, which is why you will end up paying less fees.
Tax efficiency is also a very important point that is in favor of investing in ETF funds. There are only handfuls of taxable events with the ETF funds. There is less number of transactions as compare to mutual funds. The fewer transactions mean that you will have to pay less tax, which means that you will be saving money.
With an ETF, there is hardly any type of surprises. You know what you are getting into. Since the price of ETF fluctuates all day long, this is the reason that you know ETFs price. You do not have to wait like you do with mutual funds to know the price at the end of the day.
The reason why ETFs are more attractive to the investors is that the Cost, one would find several good ETFs with very low fees as compared to the other mutual funds. Furthermore, ETFs are also good option to go with when it comes to handling the Tax Times.
The manager of the ETF does not feel the need to buy and sell the stocks constantly until and unless a situation occurs where a component of underlying index which the ETF is