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Unit 7: Efficient Market Theory

(The odds of owing one of the 10 superstocks are approximately one in six.) Of course, by Notes
owning only 15 stocks you also increase your chances of becoming fabulously rich. But
unfortunately, in investing, it is all too often true that the same things that maximize your
chances of getting rich also maximize your chances of getting poor.
If the O’Neal data are generalizable to stocks, and I believe that they are, then even 100 stocks are
not nearly enough to eliminate this very important source of financial risk.
So, yes, you can eliminate non systematic portfolio risk, as defined by Modern Portfolio Theory,
with a relatively few stocks. It’s just that nonsystematic risk is only a small part of the puzzle.
Fifteen stocks is not enough. Thirty is not enough. Even 200 are not enough. The only way to truly
minimize the risks of stock ownership is by owning the whole market.

7.5 The Efficient Frontier and Portfolio Diversification

The graph shows how volatility increases your risk of loss of principal, and how this risk
worsens as your time horizon shrinks. So all other things being equal, you would like to
minimize volatility in your portfolio.
Of course the problem is that there is another effect that works in the opposite direction: if you
limit yourself to low-risk securities, you’ll be limiting yourself to investments that tend to have
low rates of return. So what you really want to do is include some higher growth, higher risk
securities in your portfolio, but combine them in a smart way, so that some of their fluctuations
cancel each other out. (In statistical terms, you’re looking for a combined standard deviation
that’s low, relative to the standard deviations of the individual securities.) The result should
give you a high average rate of return, with less of the harmful fluctuations.

The science of risk-efficient portfolios is associated with a couple of guys (a couple of Nobel
laureates, actually) named Harry Markowitz and Bill Sharpe.
Suppose you have data for a collection of securities (like the S&P 500 stocks, for example), and
you graph the return rates and standard deviations for these securities, and for all portfolios you
can get by allocating among them. Markowitz showed that you get a region bounded by an
upward-sloping curve, which he called the efficient frontier.
Figure 7.5: Markouritz Efficient Frontier

According to Markowitz, for every point on the efficient frontier, there is at least one portfolio
that can be constructed from all available investments that has the expected risk and return
corresponding to that point.

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