What is that ‘something’, that fundamentally changed the concept of Risk?

At the onset let me wish you a fulfilling and safe 2021. Being the first article of the year, it means very special to me. I do sincerely hope that you find it equally absorbing.

We did mention specifically that two ‘discoveries’, primarily, changed the concept of Risk Measurement fundamentally. The world had always had an intuitive understanding of Risk, but one strived for a measurement, a parameter, or a number that would point towards ‘quantification’ in real terms. The theory of Probability, the mathematical ‘chance’ of happening of a certain event, or a series of events, paved the way for a deeper understanding of Risk. The Game theory, another great discovery took us a step closer to the reality – that our decisions to undertake an enterprise is dependent on the actions of the others; that everything we do is a choice out of bundle of choices available to us under limiting circumstances and that we take a call based on our own ‘risk appetite’. These simple, yet powerful, tools were leading us to a systematic approach of assigning a ‘number’ to events that have periodic occurrences.

It would be worthwhile to take a step back and understand what happens in a stock market, a ‘place’ so familiar and fascinating to us!

Markets are trading stocks (and other tradeable assets) since long. We all know that stocks, or common shares, exchange hands (ownership) through a mechanics, using a value that the buyer must agree to pay to the seller. The platform, or the Exchange, guarantees any such transfer of ownership. Of course, these happen for publicly traded stocks.

When one ‘invests’ in a stock, one ‘expects’ favorable ‘returns’. In simplest of parlance, the investor wishes the current value at a level much higher than the original cost of acquisition. If such a situation happens, we say the stock, or a portfolio (bag) of stocks is in-the-money. Let us try to write it down like this:

In-the-money Positions = Spot or Current market price of the stock – Cost price or initial acquisition price of the stock.

(Note here, I am not talking about a short position here, for sake of simplicity)

What is our biggest concern when we are in a situation as above? That we are having a ‘position’ on a stock or stocks (portfolio), and market prices do (naturally, wont they?!!) change. We are ‘exposed’ to a price risk, right? We may gain favorably, or lose depending on the market movement relative to our cost of acquisition.

The traders, investors, arbitrageurs (all market players) are faced with this situation everyday. We all are.

See the effects of a decision (buying a stock, using Game Theory) and its consequent probabilistic risk (price going up or down)!

One really has to do something about it!!

Enter Harry Markowitz!

It was in the year 1952, that an article named ”Portfolio Selection” came out in the famed Journal of Finance. The author was an unknown academic, a very young graduate named Harry Markowitz. This extremely innovative paper, the likes of which has been never seen before in the long history of Financial Markets, was a pioneering study of ‘investment risk’. The concepts discussed in the paper, and the means of doing so, would change the landscape of Risk management forever. Strangely though, Markowitz never used the word ”Risk” anywhere.

I would like to spend some efforts in bringing this very ‘first’ systematic study of market risk. I will try to use layman’s language, and no mathematics (the paper published by Markowitz is highly mathematical, using a lot of algebra and linear programing!).

The paper Markowitz was presenting dealt with a ”portfolio” or an investor’s total ‘bag of net worth’ – he never considered individual investments like stock, bonds, etc. His basic premise was that a portfolio of securities is entirely different than individual securities, and, as we shall see soon, the risk-return spectrum or pay-offs thus becomes entirely different too (in relation to single asset investing). Please note that we are talking at a time when equity investments were considered a specialized action for the strong-hearted and the experts. The weak hearted would naturally, find their rightful place in the bank deposits or government backed bonds!

His ‘language’ of the paper ( I do personally have a copy of the expanded version of the paper published in the form of an amazing book by the same name – Portfolio Selection – that I read multiple times since my MBA days more than 20 years ago!) was far from simple. He was not selling romantic ideas on stock investing or simple notions (buy low, sell high types) or back thumping bravados as were the rule of the days, but a great theory using complicated mathematics and graphs. In fact more than 75% of his paper was numerical! What did he try to say? Let us note that down first.

1. Human beings are rational decision makers.
2. Investors can (and should) manage the risks that they assume due to their actions.
3. Higher risk, in time, produce more wealth to investors (but only those who can with stand the market shocks or volatility for a long time enough).
4. A ‘variance of returns’ is an undesirable thing (this is actually the risk or the standard deviation from mean or average price/returns). This undesirable variance needs to be minimized but cannot be eradicated.
5. So from the above point # 4, we derive the concept of ‘diversification’ of the portfolio. The more we diversify, the more we minimize variance or risk. Mind you, a mindless diversification will not produce the desired objective. It has to be done in a particular way, following certain definitive principles.
6. Variance is a statistical measure of how widely the returns from an asset swing around their ‘mean’ or average. Mathematically, this concept is linked to a well known measure called the Standard Deviation or Measures of Dispersion.
7. Thus, the greater the variance around the average, the lesser will be the average return and vice versa. Isn’t it intuitive as well?
8. Investors should diversify their portfolio, and not concentrate on ‘getting the best price point’ for single assets as argued by other experts, because diversification is the BEST weapon against the variance of return. So, investment is not a single minded or one time process. It is a continuous, knowledge driven effort.
9. Diversification is also a principle based on the systematic study of the ‘correlation’ between available asset choices. This is a different discussion by itself! I will provide more insights on this when time comes.
10. In Markowitz’s own words: Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim.

Let us talk a bit (in simple words) on the above – diversification.

In a diversified portfolio, some assets will rise in price while some fall. At the very least, the rates of return among assets will differ. In a ‘rational’ decision making, let us make those diversification choices such that the rise and fall do not offset each other in exactitude! Rather let such choices contain volatility over maximizing returns of a very risky bet!

To my readers, Don’t you see the hand of the Game Theory I described in my previous article?

Look at this now. There is a close resemblance between diversification and Von Neumann’s games of strategy. Let us choose our two players here: the Investor and the Stock Market. No one knows the intentions of the other. The stock market is a very powerful opponent, so the chance of losing against it is actually quite high! A rational investor, by choosing to diversify here, an action akin to averaging the best of the bad bargains (choosing to minimizing losing rather than maximizing a killing and face a probable disaster), is simply maximizing his chances of survival. Isn’t it fascinating?!

The mathematics of diversification is just amazing. It can be mathematically proved (interested readers can certainly refer back to the text or simply talk to me) that while returns from a diversified portfolio will be equal to the average of the rates of return on its individual holding, its volatility or risk will be less than the average volatility of its individual holdings!!!!

So, even if an investor cannot maximize returns by diversification, he can certainly minimize risks by doing so! One can combine a group of risky assets having higher expected (probability) returns into a relatively low risk portfolio as long as one can minimize the co-variances, or simply correlations, among the returns of the individual securities.

The concept propounded by Markowitz was so powerful and insightful. As I said in one of my previous articles here, that the markets, hitherto, did not have a risk number, neither they cared for one. Stock markets was always considered highly risky and speculative, yet, strangely enough, no one really bothered to assign a ‘number’ to it. Markowitz’s brilliant paper were set to change all that. Stock market investing would never be the same again.

It might also be appropriate to state that Markowitz did not exactly bring stock markets in his dissertation from the beginning. It happened ‘by chance’. As he spoke with a stock broker, it struck him as an idea (to bring stock market investment into his analyses and study). The game of probability, surely, isn’t it?

Harry Markowitz’s brilliant paper is actually a culmination of the works of Pascal, Neumann, Laplace, Gauss, Bernoulli, Bayes and so many others. He introduced the concepts of the normal distribution, Central Limit Theorem, Variance-covariance, probability, game theory and linear programing – all in one model!

I personally feel that the greatest outcome of Harry Markowitz’s work is a definitive framework of what we, risk managers, refer to as the ‘‘Risk-Return” approach. In his own words, one should be in risk as well as return. All other later works, as we shall see in subsequent articles, are based on Markowitz’s premise and definitive calculations. Portfolio Managers, everywhere, use his powerful postulations and methodologies to generate returns after diversifying risk. By substituting a statistical stand-in for crude intuitions about uncertainty (the standard deviation which is a definitive measure of dispersion around the mean), Harry Markowitz transformed traditional investing (buying and hoping, of course with a deep pocket) into what is called creating ”efficient portfolios”. Efficient portfolios (efficiency is a term borrowed from engineering) minimize that ”undesirable thing” called variance while simultaneously maximizing that ”desirable thing” called making great money!

I will, in the next article, introduce the concept of the Normal Curve or Gaussian distribution from the Portfolio concepts, bring forth the innovative and powerful CAPM – the Capital Asset Pricing Model and, of course, the Black-Scholes-Merton model; and draw parallels.

Let me know how you find this article!

(My only reference is the master’s Portfolio Selection as I stated earlier)