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Don't Put All Your Eggs in One Basket: Risk, Return, and Portfolio Theory
Chapter 3. Don’t Put All Your Eggs in One Basket: Risk, Return, and Portfolio Theory
Welcome back. Previously, we learned how to measure the ‘weight’ of an asset through valuation. Today, we explore how to mix those assets to create the most delicious ‘Income Cocktail’—the world of Portfolio Theory.
“High Risk, High Return.” This phrase is the core truth of finance. However, simply taking risks is not the goal. Harry Markowitz, a giant of modern finance, mathematically proved ==“A way to reduce risk for free.”== Let’s uncover the ‘magic of diversification,’ often called the only free lunch in economics.
1. The Nature of Risk: Volatility in Numbers
In finance, risk is not just the ‘possibility of losing money.’ It means ==“The possibility that actual results will differ from expectations”==—in other words, Volatility.
(1) Expected Return
The average value of returns weighted by the probability of various future scenarios (boom, recession, etc.).
(2) Standard Deviation: The Yardstick of Risk
We measure how far returns fluctuate from the mean using Standard Deviation (). A higher standard deviation indicates a riskier asset with an unpredictable future.
2. The Magic of Diversification: The Portfolio Effect
Why don’t smart investors ‘all-in’ on a single stock?
Select individual assets with different price movements
Measure the Correlation Coefficient (ρ) between assets
Allocate investment weights to balance the mix
Total portfolio risk drops below the weighted average risk
==The Decisive Role of Correlation==: If two stocks move exactly the same way (Correlation = +1), mixing them is useless. However, if you find a pair where one smiles while the other cries (Correlation < 1), you can keep your return while drastically reducing overall risk.
3. The Efficient Frontier
Out of thousands of possible combinations, which one should we choose?
The Dominance Principle (Rational Choice)
| Scenario | Criterion | Conclusion |
|---|---|---|
| Risk is Equal | Choose higher return | Dominance Principle |
| Return is Equal | Choose lower risk | Dominance Principle |
The line connecting the best portfolios that offer the highest return for a given level of risk is called the Efficient Frontier. A rational investor must always choose a portfolio on this line.
4. Systematic vs. Unsystematic Risk
Does diversification remove all risk? Unfortunately, no.
Composition of Total Risk
Only part of the risk can be 'diversified away'.
- Unsystematic Risk: “A specific CEO made a mistake.” Risk unique to a company. CAN be eliminated.
- Systematic Risk: “Global interest rates spiked.” A wave hitting the entire market. CANNOT be eliminated.
5. Conclusion: Choose Your Risks Wisely
The heart of portfolio theory is not just avoiding risk, but ==“Strategic boldness: eliminating avoidable risks and selecting only those risks that offer compensation.”==
📚 Prof. Sean’s Selected Library
- [Against the Gods] - Peter Bernstein: An epic saga of how humanity conquered the abstract concept of ‘risk’ with numbers.
- [Pioneering Portfolio Management] - David Swensen: Insights from the legend who managed the Yale Endowment.
- [Fooled by Randomness] - Nassim Taleb: A warning that the returns we believe are skill might actually be luck (volatility).
Next time, we will learn about the exciting moment a company decides whether to start a major new project: ‘Capital Budgeting: Analyzing Feasibility with NPV and IRR.’