I believe it is safe to assume that all investors have a shared interest in maximizing their return on investments while minimizing risk (optimal portfolio). Most investors expect higher returns on investment for increased risk. There are theories associated with this investment behavior which compares different security (stock) portfolios to find the best investment choice. Being a successful investor is about a diversified portfolio where there is a balance with risk to achieve efficiency. Here is an overview on portfolio management and behavioral finance.
I. Portfolio Management Theory:
- States in order to achieve the highest possible return lower risk investments should be included (a diversified portfolio!!)
- Investors are risk averse. This means if they are assuming more risk they will require a higher potential for return (do you blame them??). Great example of this is car insurance. You would rather pay a premium then take on the full risk of paying for the entire car in an accident.
- Markowitz Portfolio Theory (modern portfolio theory)
- Investors should look at investing options based on their expected rate of return.
- Optimal Portfolio- Investors attempt to minimize risk while working to get the highest return possible. Rational behavior is used in deciding which investment to use based on their level of acceptable risk.
- A portfolio is considered efficient if no other option offers a higher return with the same or lower risk.
2. Efficient Frontier
- Takes the entire portfolio weighing the risk involved and the correlation between the securities. If you have stock “123” and stock “456”, how do these two work with each other considering their rate of risk and return? The efficient frontier is an illustration on how well the two would work with each other within a portfolio.
3. Capital Market Theory
- An addition to Markowitz’s portfolio theory. Has 8 assumptions including the fact that investors are striving for efficiency (optimal portfolio) and there are no fees or taxes added when buying or selling.
- Uses the capital asset pricing model which gives the expected rate of return of an asset (like a stock) if it is included in a diversified portfolio. It looks at its beta (non-diversifiable risk, systematic which involves the market return), and it looks at the expected risk free rate asset (a government issued asset- e.g. treasury bill).
- Capital Market Line- an illustration (a line…hence the name capital market LINE- hahaha!) which shows the expected rate of return when the risk-free asset is added. This differs from the efficient frontier in that it includes the risk free asset (people think this makes it a better model). Diversifiable risk (unsystematic): standard deviation.
- Security Market Line- an illustration which shows the expected return if a single risky asset (let’s use stock XYZ) is added to a portfolio. All original assets are plotted on a graph. If the risk (or the beta) and the expected return of XYZ is ABOVE the others already in the portfolio, then XYZ is considered UNDERVALUED and the investor should buy. BUT, if it is BELOW, then XYZ is OVERVALUED and the investor should NOT buy.
The items discussed above represents a rational investor. Behavioral finance states investors are actually not as rational (hmmmm…). There are miscellaneous theories based on the study of behavioral finance. Ones I find most interesting are:
Herd effect: not wanting to be left behind. Buying stock because everyone else is buying (Facebook going public comes to mind. Who doesn’t want a piece of that pie??)
Prospect theory: investors fear losses more than they value gain.
Escalation bias- investors will contribute more money into a failing stock than into investments that are outperforming. In other words, investors will see the decline as bargain or discount. So if you bought a stock for $50 and it declines to $40, you will buy into it because, hey, now it’s a bargain with a discount of $10.
This chapter had a lot of information on investor behavior and achieving an optimal portfolio. I hope this information was as beneficial for you as it was for me writing it. Please provide feedback! Thanks!!