What Goes In Your Portfolio?

[adios]

How do you all decide what goes in your portfolio? Well the mantra from everybody is diversify i.e. spread the risk. Of course if you buy assets whose price movements are highly correlated you're not getting the benifits of diversification. Basically what the financial literature states is that investors are not rewarded for taking on individual company risk. It can be proved quite easily (mathematically) that individual company risk can be "diversified away" by choosing a basket of stocks. Another way to put this is that for a given risk level, a well diversified portfolio has a higher expected return than a non diversified portfolio. The Capital Asset Pricing Model (a cornerstone in the development of portfolio theory and I believe a Nobel price was awarded to it's inventor), CAPM, relates risk with variance. The higher the variance of returns the higher the risk. Furthermore the CAPM uses a measure called beta to identify the riskiness of an asset. Here is a link to a very readable discussion of the CAPM:

http://www.moneychimp.com/articles/risk/classes.htm

Here are a couple of paragraphs from the article that I feel every market participant needs to consider:

"Another consequence is that CAPM implies that investing in individual stocks is pointless, because you can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class. This is why followers of MPT (modern portfolio theory) avoid stocks, and instead build portfolios out of low cost index funds.

(One point about that last paragraph. If you are trying to duplicate an expected return that's greater than that of the asset class, you have to hold "negative" cash, meaning you have to buy the index on margin. This is consistent with the big message of MPT - that trying to beat the index is inherently risky). "

There is another implication of the CAPM that's been discussed here before and that's the return rate of the asset class i.e. the risk premium afforded stock market investors (equity risk premium). Notice that if it is less than or equal to the risk free rate of return, the investor is better off not investing in the asset class, in our case stocks.

The nature of the equity risk premium and the suitability of beta as a measure of risk is widely debated. Alternative models that are based on the CAPM such as Arbitrage Pricing Models have been developed to better capture the true nature of risk premiums and measures of risk. Here is link that explains what beta is:

http://www.moneychimp.com/glossary/beta.htm

So why are we racking our brains picking individual stocks?

[scalf]

/forums/images/icons/smirk.gif tom...life's a bitch..then ya die...lol

very good points...i feel though that index funds are skewed to not maximize...as they routinely kick out poor performers...and replace with last years winners....there are actually some funds which beat appropriate indices...but few and far between...however...it's fun, for me to study the market, which underlying is a compilation of human decisions...it should be possible to beat human herd movement...but i ain't quit my day job...lol..gl /forums/images/icons/shocked.gif /forums/images/icons/club.gif

[adios]

I'm not certain that beta captures the real return potential for all issues traded on the exchanges. As Ray has pointed out many securities seem to "fly under the radar screen" i.e. they aren't that widely followed and/or their business models have characteristics that distinguish them from your run of the mill S&P 500 company. I really can't prove it but I think ineffeciencies do exist that arn't "arbitraged away" very readily.

[Yerma]

"So why are we racking our brains picking individual stocks? "

Because nobody believes in CAPM anymore.

[Zeno]

Tom: I went back to the derivation of this CAP-model (included in the web pape you posted) and here are a list of assumptions. It is important to note that these are only the assumptions the authors put in the paper! There are always a number of assumptions more deeply "hidden" within any model. A simple reading of the authors list provided below proves my point.


"The CAP-model



This section presents a derivation of the capital asset pricing model (CAPM). The CAP-model is a ceteris paribus model. It is only valid within a special set of assumptions. They are:



· Investors are risk averse individuals who maximize the expected utility of their end of period wealth. Implication: The model is a one period model.

· Investors have homogenous expectations (beliefs) about asset returns. Implication: all investors perceive identical opportunity sets. This is, everyone have the same information at the same time.

· Asset returns are distributed by the normal distribution.

· There exists a risk free asset and investors may borrow or lend unlimited amounts of this asset at a constant rate: the risk free rate (kf).

· There is a definite number of assets and their quantities are fixed within the one period world.

· All assets are perfectly divisible and priced in a perfectly competitive marked. Implication: e.g. human capital is non-existing (it is not divisible and it can’t be owned as an asset).

· Asset markets are frictionless and information is costless and simultaneously available to all investors. Implication: the borrowing rate equals the lending rate.

· There are no market imperfections such as taxes, regulations, or restrictions on short selling."

Note that nothing is said of the inflation worm that is a constant at eating up cash and that, as far as I could determine, there is no time depentent equations to anything in the model.

Although the model is probably useful in thinking about and to analyze risk and the properties of investing, its practial utility is in question. At least that it is how I see it. Others may differ, and I could be wrong.
How well does it smooth out risk and variance to an optimal point? And futher more, why diversify risk so much? Risk is what makes the market worth investing in.

There is much more on this that is interesting but enough for now.

-Zeno

[Wildbill]

Why worry about this? I think in the end people that don't properly diversify are still likely to come within a 10% band from the "perfect" portfolio. Diversification takes a whole lot of assumptions that I think are rarely accurate from investor to investor. Everyone has such different conceptions of risk and different financial positions. Does the guy that have 3 kids that are teenagers have different considerations than the childless guy? Of course he does, no model can truly reflect this.

What the average investor should know about diversification is just don't put too many eggs in one basket, yet creating the ultimate basket is something that probably is beyond their ability or really need. The biggest implication that so many people probably miss is don't invest too much in your own company. People probably learned that somewhat from Enron, but I doubt its changed that much. Further so many people invest their life and future into their own businesses, which of course can be great, but is that proper diversification? In the end academics love this kind of stuff, but lets face it their proof is always based on historical results and what would have worked if you did so and so since 1950. While its better than guessing, do we have people that think that a lot of this stuff won't be proven wrong in the next decade?

[Ray Zee]

go to one of the web sites that let you overlay graphs like yahoo. then put in the s&p or dow and different stocks you pick. soon you will see that most follow the dow fairly closely over time. so really diversification is a faulty idea. although you do want to be somewhat spread out so a few hits doesnt knock you out of the box. the real way to spread risk is to go into different investments like real estate, your business, bonds etc.
but as to stocks nothing is better than having a portfolio of stocks you know an awful lot about the company and where its going in the future. that way you beat out all the other pickers and analyists.
picking individual stocks is for the gambler or those that want to devote the time to improve their lot in life. others that are less demanding or lazy or dont have as large an amount to invest may opt for the easy way of picking index type funds for investment, and so they tend to capture the markets upward bias over time from inflation, and some productivity gains.
but as we have seen over and over when the tide goes out all boats go down. so whatever your money is in when the economy is bad you will lose some of it. not counting what you may do to hedge.

[monte_chr]

I think ultimately any strategy that has as a basis that you can know more about a certain set of stocks than the market and profit but this knowledge is ultimately likely to only acheive the return of that particular asset class with much higher risk. If anyone can accurately predict above average the stock market returns then that person should simply be fully leveraged into the stock market to the max.

The market is wild and has huge variations but for predictability it is the closest thing to a random walk you will find. MPT is very accurate in stating that trying to beat the market your are about 20% likely to succeed and 80% likely to fail.

[Ray Zee]

montr, i believe in random walk for most stocks. but if you really know something about the company you can profit above the returns of that asset class easily. that doesnt mean you should be leveraged out as that may still get you broke when all boats go out with the tide.

[monte_chr]

My point is that if you "know" a stock better than someone else you are either using insider trading data which is illegal, or you are just getting a lucky variance. It seems very improbable to me that an average person would know more about a stock, and also how that would effect the stock price to beat that particular asset class with this type of information. The large brokerage houses and mutual funds, which have a huge staff, a ton of money, and lots of resources are not able to do it.

I would ask anyone who really believes they can do this to conduct a study of those predictions and then make sure the confidence level exceeds 95% before any conclusions area drawn. Many paths can be walked on the random walk that is Wall Stress, at least in my opinion.

[Ray Zee]

many stocks do not have anaylists that follow them closely or at all. so you can get ahead of the ball. almost every stock i own i know more important things than the general public and more stuff than most insiders in the company. and it is not illegal. trading on info not available to others is or may be.
the large brokerages cant do it because they need to buy large blocks of stock. and they must do this with big companies. also they do poorly as they have political and selfish agendas rather than their customers interest in mind. anyone that does anything other than just trade thru a broker is a fish waiting to be caught.