A portfolio approach to investment
Srujani Panda / 21 Nov 2011
Sandeep Tyagi
Chairman & MD, Estee Advisors
“Investors invest in great investment ideas.” This is an obviously true statement, with every investor looking out for great investment ideas. However, a sophisticated investor should know that chasing great investment ideas in isolation, without regard to how they work together as a portfolio, is not the best approach. You may believe that by going after the best investment ideas you can build the best portfolio, but this is not true. Another way to understand this is to look at how a good cricket team is built. If we put together all the best cricketers we found, it would not necessarily make the best cricket team. We may end up with only great batsman or only great pace bowlers. To build a great team, we need to understand how individuals fit together.
The reason that getting the best cricketers does not yield the best team is that a great team needs a balance of various skills. Similarly, the reason why a set of various investments works better than one kind of investment is the way risk behaves in a portfolio, compared with an individual investment. While investing, a good investor puts a portfolio together by combining various investment ideas.
Every investment is about returns and risk. When we make multiple investments, the returns get added, but the risks do not work in the same way. Let us understand this concept with an example.
In the following table, we can see the annualised returns of two different stocks – HUL and Bharti Telecom – over the years. We also see the standard deviation (a statistical measure that measures how much the returns varied over the period) of each stock. Standard deviation is a good measure of the risk associated with the investment. When we create a portfolio, buying both the stocks in equal value, we see that the return of this portfolio is the average of the return of each stock. However, the standard deviation has been reduced below the individual standard deviation of each stock.
This simple insight was first articulated by Harry Markowitz in a 1955 paper, who was honoured with the Nobel Prize in the year 1990 for his pioneering work. Simply stated, he found that combining various investments reduces the variability of the return without impacting the expected return. This is as close to a free lunch as we get in finance.
The way in which the variability reduces is based on the relationship between the investments – this is the concept of diversification of risk. Diversification of risk works because the returns on two assets are not perfectly correlated. Let us say that you have two choices – to invest in two oil companies, or to invest in an oil company and an airline company. If the price of oil reduces, the profits of both the oil companies will reduce. It would be better to have an investment in an oil company and an airline company, because the profit of the airline company is likely to increase as the price of oil reduces. When we take on investments without understanding their relationship with each other, we risk getting concentrated exposure to certain types of risk.
Many investors fall into the trap of repeating the one thing that worked. Let us say that you invest in a real estate company and the stock moves up quite a bit. You find other real estate companies and invest in them as well. Surely, more of a good thing is better than less, right? Well, not always. This strategy will lead you to have a high concentration in one sector of the economy, and if there is any problem with the sector, all your investments go down together.
Professional and disciplined investors follow portfolio optimisation methods rigorously. They limit their risk in each sector, and put together a set of stocks which are relatively uncorrelated. This improves their risk-return characteristics.
This concept is easy to understand, but very hard to implement. We all have put in too much money not only in real estate, but also in other ‘hot sectors’ like internet companies or banks. So, as you invest your money, take a portfolio approach and put together different investment ideas in a way that they are not highly correlated. This will give you good returns, while reducing your overall risk. As the old saying goes, do not put all your eggs in one basket.
The author runs an investment firm, which uses systematic investment methods, including rigorous portfolio optimisation.
Chairman & MD, Estee Advisors
“Investors invest in great investment ideas.” This is an obviously true statement, with every investor looking out for great investment ideas. However, a sophisticated investor should know that chasing great investment ideas in isolation, without regard to how they work together as a portfolio, is not the best approach. You may believe that by going after the best investment ideas you can build the best portfolio, but this is not true. Another way to understand this is to look at how a good cricket team is built. If we put together all the best cricketers we found, it would not necessarily make the best cricket team. We may end up with only great batsman or only great pace bowlers. To build a great team, we need to understand how individuals fit together.
The reason that getting the best cricketers does not yield the best team is that a great team needs a balance of various skills. Similarly, the reason why a set of various investments works better than one kind of investment is the way risk behaves in a portfolio, compared with an individual investment. While investing, a good investor puts a portfolio together by combining various investment ideas.
Every investment is about returns and risk. When we make multiple investments, the returns get added, but the risks do not work in the same way. Let us understand this concept with an example.
In the following table, we can see the annualised returns of two different stocks – HUL and Bharti Telecom – over the years. We also see the standard deviation (a statistical measure that measures how much the returns varied over the period) of each stock. Standard deviation is a good measure of the risk associated with the investment. When we create a portfolio, buying both the stocks in equal value, we see that the return of this portfolio is the average of the return of each stock. However, the standard deviation has been reduced below the individual standard deviation of each stock.
| Parameter | HUL | BHARTI TEL. | 50%-50% Portfolio |
| Annualised Return | 12.20% | 35.50% | 23.80% |
| Annualised Standard Deviation | 32.40% | 41.80% | 29.70% |
This simple insight was first articulated by Harry Markowitz in a 1955 paper, who was honoured with the Nobel Prize in the year 1990 for his pioneering work. Simply stated, he found that combining various investments reduces the variability of the return without impacting the expected return. This is as close to a free lunch as we get in finance.
The way in which the variability reduces is based on the relationship between the investments – this is the concept of diversification of risk. Diversification of risk works because the returns on two assets are not perfectly correlated. Let us say that you have two choices – to invest in two oil companies, or to invest in an oil company and an airline company. If the price of oil reduces, the profits of both the oil companies will reduce. It would be better to have an investment in an oil company and an airline company, because the profit of the airline company is likely to increase as the price of oil reduces. When we take on investments without understanding their relationship with each other, we risk getting concentrated exposure to certain types of risk.
Many investors fall into the trap of repeating the one thing that worked. Let us say that you invest in a real estate company and the stock moves up quite a bit. You find other real estate companies and invest in them as well. Surely, more of a good thing is better than less, right? Well, not always. This strategy will lead you to have a high concentration in one sector of the economy, and if there is any problem with the sector, all your investments go down together.
Professional and disciplined investors follow portfolio optimisation methods rigorously. They limit their risk in each sector, and put together a set of stocks which are relatively uncorrelated. This improves their risk-return characteristics.
This concept is easy to understand, but very hard to implement. We all have put in too much money not only in real estate, but also in other ‘hot sectors’ like internet companies or banks. So, as you invest your money, take a portfolio approach and put together different investment ideas in a way that they are not highly correlated. This will give you good returns, while reducing your overall risk. As the old saying goes, do not put all your eggs in one basket.
The author runs an investment firm, which uses systematic investment methods, including rigorous portfolio optimisation.
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