Should Investors Focus On Risk Rather Than Profit?

According to the modern portfolio theory (MPT), financial asset prices always fully reflect all available and relevant information, and any adjustment to new information is virtually instantaneous. In this way of thinking, asset prices respond only to the unexpected part of any information, since the expected part is already embedded in prices.

For instance, if the central bank raises interest rates by 0.5 percent, and if market participants anticipated this action, asset prices will reflect this expected increase prior to the central bank raising interest rates. Note that once the central bank lifts the interest rate by 0.5 percent this increase will have no effect on asset prices since it is already embedded in asset prices.

Should, however, the central bank raise interest rates by 1 percent, rather than the 0.5 percent expected by market participants, then the prices of financial assets will react to this additional increase.

According to the MPT, the individual investor cannot outsmart the market by trading based on the available information since the available information is already contained in asset prices.

This means that methods, which attempt to extract information from historical data, such as fundamental analysis or technical analysis, are of little help. For whatever an analyst uncovers in the data is already known to the market and hence will not assist in “making money.”

By this logic, stock market prices move in response to new, unexpected information. Since by definition the unexpected cannot be known, this implies that an individual’s chances of anticipating the general direction of the market are as good as anyone else’s chances.

Following the MPT, since the future direction of the stock market cannot be known, then the only way of earning above-average returns is to assume greater risk. A security whose returns are not expected to deviate significantly from its historical average is termed as a low risk. A security whose returns are volatile from year to year is regarded as risky.

The MPT assumes that investors are risk-averse and they want high guaranteed returns. To comply with this assumption the MPT instructs investors on how to combine stocks in their portfolios to give them the least possible risk consistent with the return they seek. MPT shows that if an investor wants to reduce investment risk, he should practice diversification.

According to the MPT, a portfolio of volatile stocks can be combined together and this in turn will lead to a reduction of the overall risk of the portfolio. The guiding principle for combining stocks is that each stock represents activities that are affected by given factors differently. Once combined, these differences will cancel each other out, thereby reducing the total risk, so it is held.

Consider the following simple example:

 

Activity A

Activity B

Cold Weather

20%

–10%

Warm Weather

–10%

20%

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