Passive Investing Theory, part 4: Portfolio Theory



http://sensibleinvesting.tv -- the independent voice of passive investing Fourth and Final Part One of the core principles of passive investing is that investors with a wide spread of assets take a much lower risk than those who hold just one asset. Investors should therefore ensure that their portfolios are highly diversified. It seems common sense that owning assets with a negative correlation - a combination of shares and bonds, for example - should reduce risk. When one goes up in price, the other usually comes down. But in 1952, Harry Markowitz, an economist at the University of Chicago, developed what he called Portfolio Theory, which mathematically proved it. The theory (sometimes called Modern Portfolio Theory) also showed that diversification lowers risk even if assets' returns are not negatively correlated - and indeed, even if they're positively correlated. This is the formula Markowitz came up with for the standard deviation of expected returns. The theory has been developed by many different academics in the meantime, but it paved the way for portfolio construction as we know it today. William Sharpe was an economist at the University of Washington who, in 1964, had a paper published in the Journal of Finance outlining the Capital Asset Pricing Model. The Capital Asset Pricing Model was based on just one variable - market risk. It was later expanded on by Professors Eugene Fama and Kenneth French at the University of Chicago. The Fama-French Three-Factor Model added two more dimensions - size and value. The model for constructing portfolios that Harry Markowitz developed - and that Sharpe, Fama and French improved upon - still has its critics. Even among proponents of passive investing, there are those who say it doesn't tell the whole story. But Portfolio Theory has undoubtedly had a major impact on how we invest. The award of the Nobel Prize in Economics to Markowitz and Sharpe in 1990 was belated recognition for the huge contribution they made to our understanding of how all of us, as investors, can best balance risk and reward when saving for the future. For more videos like this one, visit http://sensibleinvesting.tv

Comments

  1. The Markowitz formula is wrong. the 2s should be ^2
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Visibility: 5623

Duration: 4m 19s

Rating: 19