3.2.2 Applying portfolio theory

In the previous section, you looked at the risk–return trade-off between Gelato and Hotchoc. However, by combining the two shares in a portfolio, it is possible for the investor to reach a better outcome. Watch this short animation about portfolio theory.

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MARTIN UPTON

We all know not to put all of our eggs in the one basket. The problem is how many eggs do you need to put in how many baskets to be safe? That’s where portfolio theory comes in and this example shows how to apply it.

At point A the investor holds 100% of their investment in Hotchoc shares.

Now here is point C. In this portfolio we have 62% Gelato shares and 38% Hotchoc shares. This portfolio bears the same risk as at point A, but the expected return is now 9.5%, significantly higher than the 4.4% expected at point A. So by combining the two shares in a portfolio it is possible to increase expected return without increasing risk. This shows how powerful diversification can be in tackling risk and return.

All possible combinations of Gelato and Hotchoc shares are shown by the curve that links together all the possible portfolios. For an investor seeking the least amount of risk, point D might be chosen, where the risk is 6.0%. Of course, in the real world, the investor can choose between thousands of shares, in any number of combinations.

To illustrate how diversification works for three shares, consider this. Let’s add a company making ice lollies: Icepop. At point E, 100% of the portfolio is allocated to Icepop shares. Various combinations of Icepop and Hotchoc are available along the curve drawn between A and E. As are combinations of Hotchoc and Gelato already shown in the curve joining A and B. The key to this new scenario is that the investor can now choose to combine all three shares in a portfolio.

A third curve can be drawn. This draws together all combinations that are possible from the three shares, Hotchoc, Gelato and Icepop. This curve is called the efficient frontier. It represents points at which the investor can get the highest expected return for a given risk, and the lowest level of risk for a given expected return. Economists refer to these as “optimal” combinations of risk and return. By reaching the efficient frontier the investor is unable to improve their risk-return trade-off. But basically, this use of statistical tools to achieve efficient diversification is just another way to put into practice the well-known adage “don’t put all your eggs in one basket”.

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The conclusion of the animation is that by reaching the so-called ‘efficient frontier’, the investor is unable to improve their risk-return trade-off. The portfolios on the efficient frontier are said to be Markowitz efficient, named after Harry Markowitz (1959), who was the first person to work out the implications for the mathematics of combining shares into portfolios. By following a strategy to reach the efficient frontier, investors are said to employ Markowitz diversification.

This section concludes the analysis of portfolio theory and the rationale of investment diversification.

Further supporting information the topics below is provided in the document Understanding risk versus return in portfolio theory [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] .