This is an interesting article from a theoretical point of view where I’m going to talk about people who have studied the mechanics of financial markets, here are the theories of Harry Markowitz and Burton Malkiel.
I start with Harry Markowitz’s theory that it refers to risk diversification across different stocks, his famous phrase is “don’t put all the eggs in the same basket.” This economic theory is based on portfolio construction where it is essential to identify a certain number of financial titles, with the aim of maximizing return and reducing risk (diversification).
Harry Markowitz and another Gorge Dantzig economist have studied how to create an asset allocation to reduce risk/loss in relation to the time horizon and investor objectives.
One of the most important rules of Harry Markowitz’s theory is that a set of stoks don’t have to be related to each other, I think you’ve already heard of correlation and decorrelation when someone doing an analysis goes to see these details.
Harry Markowitz’s portfolio theory is a key element in helping investors diversify, reduce risk and increase profits. Two questions need to be asked:
• How much do I want or think to earn from “x” shares in the future?
• What is my risk based on the statistical variance of performance?
The correlation coefficient of Markowitz’s theory is based on the yield and statistical variance of a portfolio, for example, take shares A and B.
The correlation coefficient between the two financial instruments is contained between -1 and +1 leading us to 3 different scenarios:
|Greater than 0
|A and B related positively
|Less than 0
|A and B related negatively
|Equal to 0
|A and B not related
Once the statistical calculation of returns has been made, the investor will be able to choose the best solution based on his risk profile by reducing the probability of loss.
The indifference curve as the word says is formed by different curves (they can be many if not infinite), depending on the risk/reward ratio. The curve of indifference I remember that however can change many times over time because every investor has a different perception of risk/return.
A risk-oriented investor will be placed in the right area while an investor with a low risk profile will be in the left area.
After Nobel prize winner Harry Markowitz’s portfolio theory we arrive at the Random Walk theory developed by Burton Malkiel, although in truth the first to define this theory was the mathematician French Louis Bachelier pointing out that stock prices go randomly.
For Burton Malkiel, the random walk says that rising or falling prices are driven by pure randomness, in practice they discount information automatically.
Barton Malkiel’s theory is based on the principle of an efficient market where prices are not predictable in fact those who believe this theory of random walk think that it is not possible to do better than the market. Followers of random walk theory don’t believe in the intrinsic value of a financial instrument, I personally don’t believe in all this because I think the investor has a chance to outperform the market.
Through the study of technical analysis and experience you can make predictions with a good probability of success, unfortunately in the financial markets there is no certainty and there will never be, as I said before we talk about probabilities.
Financial markets are not efficient because they are urged, for example, by the injection of money from central banks or speculative bubbles where prices do not exactly follow random trends. During the month of March 2020 when Covid broke out, markets discounted the information and then investors went short.
Knowing these theories is important to have a comparison with different ideas but it is not enough because you have to study every day through technical analysis and behavioral analysis.