Modern Portfolio Theory And Your Understanding Of Risk

Life isn’t much fun when you’re living paycheck to paycheck, low credit score, and you’re in debt. You don’t need to be a math wiz to do all the calculations and budgeting. Just the basic addition and subtraction will suffice.

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Life is much easier when you have good money management skills. It helps if you have a handle on your impulse. Suppose you’re on the fence about a big upcoming purchase, don’t just assume you can buy it, as it’ll only cost you a week worth of your salary. Double-check that you can actually afford the purchase and don’t have any other non-negotiable(Vehicle rego, rent, insurance and bills etc.) expenses coming your way.

Managing Money —

Don’t take on unnecessary loans or debt just because you are eligible.

You’ve been working your full-time job for a couple of years now, all of a sudden, you get an email from your bank saying you’re eligible for a personal loan. You think to yourself, I have been working hard, I deserve vacation or car upgrade, and now I am qualified to take out a personal loan! DON’T DO IT.

Don’t not use a credit card but limit its usage. 

A credit card is handy for your credit score. Some individuals don’t use credit cards at all; they might have personal reasons for this. But having one credit card with the primary purpose of increasing your credit rating can improve your financial health by a lot.

Have a budget.

This goes without saying if you need to manage your money. Budget is like the foundation upon which the empire of personal wealth stands. Make a budget, follow it, track your expenses, and allow yourself a limit for unbudgeted spending(5–7% works for me). When you budget every month, you have a rough idea of how much money you need to get by each month.

Save money at the start of every pay cycle.

 Initially, my dad advised me to save money each month. It worked alright for a while, but I realised that he only suggested monthly savings because he got paid monthly. I get paid weekly and fortnightly from my employers to save weekly, which is much easier. Save and invest your money at the beginning of your pay cycle before you spend.

You plan and stick to your budget every month, but are you contributing to your long term goal too? Track your progress at least once a month. Analysing reports every month gives you comprehensive data needed to predict whether you need to change your budget.

With your budget in place and data from your reports, you have your finances under control. You can hit your savings target every month. Now, how can you utilise your savings to bring your goal post closer to you? This is when Modern Portfolio Theory comes into the equation.

Modern Portfolio Theory or Mean-variable Analysis

In 1952, an economist named Harry Markowitz wrote his dissertation on “portfolio selection” in the journal of finance 1952. During his time as a professor of Finance at the Baruch College of the city university of New York, in 1990, he won the Noble Prize in economics science for Modern Portfolio Theory.

Modern Portfolio Theory

It’s a method that helps low-risk-tolerant investors construct a well-diversified portfolio to maximise return on investments. MPT argues that it is not about the risk and return from one asset in the portfolio; how that one stock’s performance affects the overall portfolio return that matters.

MPT focuses on the relationship between an asset in a portfolio, in addition to the individual risk each asset carries. It exploits the fact that a negatively correlated investment can offset losses that are incurred on other stocks. For example, every time the stock market takes a dive, price or gold hikes up as investors flee from high risk to stable investments.

In other words, MPT says that you can hold high-risk assets as long as you have a good balance of low risk and stable investments in the mix. An investment fund that follows MPT is likely to have 40% of large-cap stocks from the index, 30% of the overseas stock, 15% short-medium term bonds, 10% small-cap stocks and 5% cash. Even with this approach, it’s crucial to periodically balance your portfolio to keep the same amount of weight in each asset class.

By closely following the MPT, an individual can achieve a better overall return with relatively low risk. One other way to keep the risk exposure to the minimum is to buy two ETF’s (one based on high-risk investments such as large, medium and small-cap stocks. And another with low-risk assets such as cash market, gold and govt bonds. Periodically balancing the percentages back to original weight can produce identical results without buying all assets separately and paying high brokerage fees.)

To reduce risk it is necessary to avoid a portfolio whose securities are highly correlated with each other — Harry Markowitz.

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