Mark T. Hebner

In the traditional 12-Step Program, it is customary to relinquish your control to a higher power. The Nobel Prize in Economics is an award for outstanding contributions to the science of economics and is generally considered one of the most prestigious awards for that science. The nomination, review and final awarding process is a rigorous one, including ample peer review and scrutiny of an individual’s body of work and its quantifiable contribution to the world of economics. Higher power, indeed.

 

One of the most important things to come out of all these economic minds is Modern Portfolio Theory. This theory began when then University of Chicago Ph.D. student Harry Markowitz came to a realization about risk and return. He spent copious time studying the leading investment guides used by professional money managers. The guides recommended investors should invest in stocks with the highest expected return.  It suddenly occurred to Markowitz that investors should consider risk as well as return. And with that realization came the spark that lit the inferno of scholarly work from the greatest economic minds in the world, forming what we now know as Modern Portfolio Theory.

 

There are 5 basic points that make up Modern Portfolio Theory

 

1. Markets move randomly and are efficiently priced

 

2. Allocation of priced risk factors determines the risk for investors

 

3. Diversification reduces your risk and increases your returns

 

4. Risk Exposure must be matched to one’s risk capacity

 

5. Probability and statistics help investors control the risk of their investments.

Harry Markowitz recently said, “If it perfectly fine to own an undiversified portfolio so long as God Himself is providing the portfolio advice.” Diversification in investing is the process of spreading out risk. No one knows what is going to happen in the short term to a subset of stocks in the index. The graph below takes a look at a single stock in an index versus the entire index as seen in.
 

 

A subset of the index (like Large Value or Large Growth) would actually be another index altogether with different risk and return characteristics. If one takes it to the extreme, one stand alone stock represents its own index, but it has a very high risk and it offers no additional expected return over the asset class to which it belongs.

 

Unfortunately, this type of information doesn’t come to light in the main stream media. Instead, many investors are comfortable listening to people like  

 

 

telling us how to invest our money…incorrectly. Certainly, we have a higher power.

 

Nobel Laureate Paul Samuelson once said, "This message (that attempting to beat the market is futile) can never be sold on Wall Street because it is in effect telling stock analysts to drop dead." As we try to get the word out against the expensive and destructive farce, you can help.

 

 

Join the movement. Improve the financial futures of yourself and those you care about. Let the active managers know that the con is over and the massive wealth extraction will be reversed!