Theory. We hated it in school. What practical use would the Pythagorean Theorem or Deconstructionism have in our lives?
Many feel the same way about investment theory. Explaining modern portfolio theory to your colleagues at a cocktail party may make you seem erudite, but will understanding it make you a better investor? Yes, it can. The trick is putting the theory in context.
The fifth level of the Learning Centre's Portfolio lessons will explore some of the major topics in portfolio theory, those ideas that form the basis of how people invest and build portfolios. We'll also summarise some ongoing investment debates. By questioning many of the old rules and offering their theories, today's financial scholars and observers prove that investing is a learning experience that never ends.
Efficient markets theory
Burton Malkiel's A Random Walk Down Wall Street, first published in 1973, popularised this theory, which says that stock prices reflect all the publicly available information about the companies. Stock prices may not be "right," but they're as correct as they possibly can be. There's no point in trying to beat the market, suggests the theory. Just index it.
Some—including most fund managers—disagree. They feel that they can find mispriced securities, or opportunities where a stock's price does not accurately reflect everything about the company. We'll explore both sides of the issue in our next lesson.
Modern portfolio theory
Back in the 1950s, Harry Markowitz pointed out what is now obvious: The more return you can expect from an investment, the greater the risk inherent in that investment. Modern Portfolio Theory says that you can limit your volatility by spreading your risk among different types of investments.
We'll detail the ins and outs of MPT in portfolio lesson 5.3.
Asset allocation is ‘it’
In the mid-1980s, Gary Brinson, Randolph Hood, and Gilbert Beebower changed the way investment pros and individual investors approached investing. In their not-so-catchily-titled breakthrough paper, Determinants of Portfolio Performance, the trio proved that asset allocation explained 93.6% of the variation in a portfolio's return.
The financial community interpreted Brinson, Hood, and Beebower's findings to mean that asset allocation was the be-all and end-all of portfolio construction. It's where financial advisers and investors should spend most of their effort, they said. Which securities you chose for your portfolio mattered little. Your asset allocation was "it."
A decade later, some financial advisers and observers began to question that interpretation. Did which securities you chose really mean so little to your overall returns? Find out in lesson 5.4.
Can foreign stocks really diversify your portfolio
Most tutorials about diversification—including courses in Morningstar's Investing Classroom—say that foreign stocks can help diversify a portfolio. That assertion is based on what's known as the efficient frontier, or the point at which you can get the best return for your portfolio with the least amount of risk.
But as the world's stock markets mature, some question whether foreign stocks can continue to diversify a portfolio as they have in the past. And if investors want to use foreign stocks as diversifiers, which types of foreign stocks should they choose?
We'll explore what role different types of foreign stocks can play in a portfolio in lesson 5.5.
The ‘better’ approach
Value investing certainly has its share of supporters. In the 1930s, Benjamin Graham argued that the best way to invest was to choose stocks with low prices relative to their asset values. In the early 1990s, several studies (including one by Josef Lakonishok, Robert Vishny, and Andrei Shleifer and another by Eugene Fama and Kenneth French) showed that value strategies do, indeed, outperform growth strategies.
Value investing's edge makes sense. Undervalued stocks ought to outperform overvalued stocks. But as value stocks badly lagged their growth counterparts in the 1990s, some wondered whether value had lost its edge.
We explore both sides of the issue in lesson 5.6.
Measuring fund manager skill
Measuring how talented a fund manager is simple, say many investors. The skilled fund managers are the ones who beat the index they track. Or the ones whose funds earn 5-star ratings from Morningstar. Or the ones who receive high alphas.
These measures certainly could indicate that a manager is skilled. Or he may just be lucky. Find out how to tell the difference in lesson 5.7.
The small company advantage: fact or fiction
In the early 1980s, Rolf Banz introduced the world to the small-company premium. Banz's elaborate database showed that small-company stocks provided greater returns than larger-company stocks. Banz's findings dovetailed with what Modern Portfolio Theory said: risk and return are related. The small-cap premium compensates investors for the extra risk that comes with investing in small companies.
By the new millennium, however, critics had shot several holes in Banz's arguments—and in his data. Portfolio lesson 5.8 explains whether this small-cap "premium" really exists, and what that means for your portfolio.
The demise of dividends
A stock's total return is made up of two things: the change in the investment's price and any earnings the company pays out in the form of dividends. Throughout most of the 1900s, about half of an investment's return came from price changes with the other half coming from dividends.
As we entered 2000, though, yields decreased and dividends had become a quaint concept. Why the decline? Will the dividend ever stage a comeback? And what does the demise of the dividend mean for your investments? Find out in Portfolios 5.9.
Behavioural finance
Imagine being able to learn from your mistakes without ever making them. That would've prevented a lot of bad dates, poor clothing choices, and flat dinners.
In investing, the emerging field of behavioural finance studies the psychology and behaviours of investors to see where they make mistakes. Learn how to spot and correct your investment mistakes, and you may find yourself on the path to greater profits.
Lesson 5.10 covers some of the most common mistakes that investors make.
