Explore Secrets of Passive Investment by Portfolio Diversification

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Explore Secrets of Passive Investment by Portfolio Diversification

THE SECRET OF PASSIVE INVESTING

When it comes down to choosing what to do with your savings the majority of people will identify the most common securities such as trading Stocks, Bonds and Mutual Funds as well as perhaps Gold. Of course, these investments options involve some risk, in that their price can go down as well up. Inevitably there is the possibility that one day you may check your balance and see that it has fallen. However, the possibility of financial loss is offset by the fact that you also have a very high probability of financial gain.

Now, while we may be well aware that the financial markets may also fall, it is still necessary to understand this risk. Understanding risk helps us decide how to manage it, and will help us build low risk portfolio that overall, have lower levels of risk than any single security for a given level of return. The correct and diligent management in passive investing can create superior returns and prove to be very cost-effective.

FINANCIAL MARKETS, EFFICIENT MARKET HYPOTHESIS & RANDOM WALK THEORY

Efficient Market Hypothesis states that Public and Liquid Markets security prices fully reflect all available information. This means that trying to beat the market is more a matter of luck than a matter of skill. The hypothesis has three forms; weak, semi-strong and strong.

Weak-Form Efficient Market Hypothesis: The weak form states that neither past price nor volume has any relationship with future price. Therefore Technical Analysis, or using charts, is ineffective.

Semi-Strong Efficient Market Hypothesis: The semi-strong says that stock prices adjust rapidly to available market and non-market information. Therefore, in this case, Fundamental Analysis is not able to produce superior returns.

Strong-Form Efficient Market Hypothesis: The strong form states that price reflects all public and private information. That is, market or non-market, as well as inside information, are all factored into price. Therefore excess returns are not possible to achieve on a consistent basis.

The Efficient Market Hypothesis ties into another concept the Random Walk Theory. In this latter case, the market is likened to a drunken man walking down the street. At some point, he will swerve to the right and then at another to the left.  These swings from right to left are independent of each other; that is to say, what happened in the past cannot help in determining what will happen next. In short, price changes and direction are totally unpredictable.

Both theories have often been challenged by some academics making the claim that these two concepts are incorrect. However, academia has produced many white papers that show how these concepts still apply.  And there is a logical reason these ideas would be challenged. There is a Psychology factor; it is human nature to be active, and therefore, to be in control. If we invest passively, then we are not the owners of our destiny. We feel less important and of course, our egos cannot feed themselves on the last greatest stock pick.

THE MARKET IS THE MOST CONSISTENT WINNER

Despite the lack of satisfaction that may come from passive investing it is hard to prove it can be beaten. Many investment managers can show records of various years with relatively decent returns, but it would be extremely difficult to find managers that can display a decade of out-performing returns, let alone a lifetime. Whereas holding investments in the broad Stock Market has consistently out-performed many active managers.

If you were invested in the Dow Jones Industrial Stock Market Index in year 1900 with $10,000 and you stayed the full course, through all the highs and lows, your investment would now be worth $3,313,915. I know that sounds incredible and you're thinking $10,000 was a lot of money back in 1900. Yes, it was, it was worth around $291,000 in today’s money. So the market multiplied that by more than 11.

Jones Chart

WHY A BROAD PORTFOLIO MAKES THE DIFFERENCE

It has been shown that portfolio diversification will significantly reduce the overall risk. Diversification means holding various assets whose returns are not driven by the same factors. This means low or no correlation of returns, which will create a portfolio with a lower risk than the sum of its elements.

Markowitz came up with a model now widely known and accepted, called the Modern Portfolio Theory. This theory contends that there are two types of assets; Risky Assets and Risk-Free Assets. An investor then chooses how much risk to take on by investing more or less in risky assets. This leads to the creation of the efficient frontier, which is a graph showing what return to expect for any given level of risk.

However, for modern portfolio theory to hold there are various presumptions, one is that the risky portion of the portfolio contains all risky assets. If an investor is invested across all risky assets, then their total risk is only systemic. That is to say, they are not exposed to any single risk factor which may affect an industry or a particular corporation.  This improves downside protection of the portfolio; if you are heavily invested in one asset which takes a large loss in price your portfolio is greatly affected. Like the old adage says, "Never Put All Your Eggs in One Basket".

Summarizing

Passive Investing in the long term is more likely to produce positive returns on a consistent basis. Active management which attempts to time the markets and select the best performing stocks may show some out-performance, but are not as likely to be as consistent as the general market.

Credit Suisse Hedge Fund Index has had an annual return, net of fees, of 7.96% since inception in January 1994; the S&P 500 Index had an annual return of 8.76%. It is also easier to choose the wrong manager when investing in active management, as these managers are trying to beat the market and use strategies that can cause dire results. A passive manager is more concerned about portfolio management and analysis, and about constructing an adequate portfolio given the investor's needs.


Author: Gino D'Alessio 


You should absolutely read the other articles mentioned below for the full picture on passive investing, how you can benefit from it and what we offer in the free portfolio.


 




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