About Investing

One can think of modern investing as being based on two common sense principles.  The first is the "don't put all your eggs in one basket" principle.  Investors call the dictum "diversification", which, in its practical form, means an investment portfolio consisting of many securities that represent a cross section of industries.  Diversification works because an economic event affects different industries differently.  For example, an increase in oil price is unfavorable for the airline industry but favorable for the petroleum industry.  Therefore, oil company stocks usually move up with the increase in oil price, while airline stocks down.  Another example of an economic event is an interest rate increase, which hurts everyone, but not necessarily to the same degree.  It causes more pain in the housing industry than in the retail industry.  Thus, the stock of a construction company suffers more than the stock of a retail company in a higher-rate environment.  Diversification also works because the impact of an economic event may not be the same for all companies even within the same industry.  Take the retail industry, for example.  Higher interest rate affects each retailer differently depending on the retailer's market segment.  The more sensitive the market segment is to higher interest rate, the worse the retailer's stock.  Because businesses are unevenly affected by economic events, the number and mix of securities in the portfolio determine how well diversification works.  A portfolio consisting of only stocks requires as little as twenty diverse stocks to be well diversified, some studies suggested.  A portfolio consisting of only mutual funds has no minimum requirement.  A mutual fund is a collection of securities - stocks, bonds, money market, etc - managed by an investment company and jointly owned by a group of investors.  Every mutual fund is created with a particular investment objective to meet one of three basic targets: current income, future growth, both income & growth.  Although a mutual fund is already a diversified portfolio within its investment objectives, investors should diversify further by investing in multiple funds with different investment objectives.

The second is the "no pain, no gain" principle.  "Pain" refers to higher risk, while "gain" to higher expected return.  According to this maxim, the only way an investor can improve her expected return is by taking higher risk profile on her diversified portfolio.  Note that it is not the higher risk of an individual security that necessarily corresponds to higher return.  Rather, it is the risk of all securities that make up the portfolio, taken collectively (i.e. portfolio risk), that matters.  It is mathematically possible for an individual security to be risky, but when added to a portfolio it actually reduces the overall portfolio risk.  It is only by increasing portfolio risk that an investor "deserves" to be compensated with higher expected return.  Many studies have indeed shown that, on average, investors bearing greater risk did receive higher rates of return.  The question is how should an investor increase or decrease risk to get the expected return he wants.  Furthermore, how should an investor combine securities - stocks, or mutual funds, or both - to create a portfolio with the expected return he seeks, but with the least risk possible?  Modern Portfolio Theory, or MPT as it is popularly known, provides the answer.  Using MPT, an investor can create an efficient investment portfolio - a portfolio that yields the highest expected return for a given risk, or, alternatively, yields the minimum risk for a given expected return.  On a historical note, Harry Markowitz developed MPT, and it was a ground breaking theory for which he later received the Nobel Prize in economics.

          For most of us, we would begin the investing process by making a list of stocks, or mutual funds, or both that "experts" and friends have recommended over time.  From this list, we would then study each security in more detail.  Nowadays, information about a company stock or a mutual fund is abundantly available on the internet, business papers, business magazines, and sometimes on TV.  If the security is a stock, we would normally rely on research reports prepared by securities analysts.  If, after reading research reports, we find buy stories on a stock credible, we would include the stock in the portfolio.  Likewise, if we find "score cards" on a mutual fund attractive, we would include the fund in the portfolio.  After we are through with the selection process, we would need to proportion (allocate) optimally the securities using MPT.  The computing tools to do so is Portfolio Designer.  Once we find an efficient portfolio that gives the risk-return profile we seek, we would then buy the securities to actually form the portfolio.  At this time, we could not be sure of the return we would eventually get.  The eventual portfolio return, whether positive (gain) or negative (loss), depends on the future prices of the component securities.  This uncertainty is the risk that we take for potentially getting a "higher than bank interest rate" return.