Modern portfolio theory (MPT) was first introduced in the 1950s by Harry Markowitz. MPT emphases the concept of maximising the return investors could earn in their investment portfolio, bearing in mind a given level of market risk.
The MPT is based on the primary assumption that all investors are risk averse, meaning that investors will only take on more risk if a higher return is expected. Markowitz argued, that the added value of an additional security to a portfolio needs to be measured with its relationship to all the existing securities in a portfolio and that the individual risk of a security is irrelevant, as it is the correlation between securities that will determine the overall risk of the portfolio.
The correlation, which ranges between -1.0 and 1.0, is a statistical calculation that computes the strength of the relationship between the relative movements of two variables. A correlation of 1.0 indicates perfectly correlated assets, a correlation of 0 indicates that there is no association between two variables and a correlation of -1.0 indicates perfectly negatively correlated assets. This means that, in a hypothetical two-asset portfolio the total risk of the portfolio will be lower than the aggregate risk of the individual assets, as long as the correlation of the securities is lower than 1.0.
The process of identifying assets with a low correlation under the MPT, lessens the specific or idiosyncratic risk inherent in each investment, with most diversification benefits achieved at approximately 30 assets. All possible combinations of risky asset portfolios are constructed to identify those portfolios with the highest return for any given level of risk. The set of these portfolios is collectively referred to as the Markowitz efficient frontier.
It is important to note that risk can never be completely eliminated, as systematic risk (also referred to as market risk) is always present. Market risks are risks that can disturb the economic market in general or a large portion of it.
The FAAMG is an abbreviation for the top-performing tech stocks in the US market, being, Facebook, Amazon, Apple, Microsoft and Alphabet’s Google. It’s no surprise that these tech giants have dominated the market, with Apple and Microsoft surging by 86 per cent and 55 per cent in 2019, respectively.
The FAAMG stocks now make up a whopping 17.3 per cent of the total market capitalisation of the S&P 500, with Apple representing 4.8 per cent, Microsoft 4.6 per cent, Alphabet 3.2 per cent, Amazon 2.9 per cent and Facebook 1.9 per cent (data as at 10 January 2020). This rising concentration risk is raising concern between market participants and this ties in with the correlation concept mentioned above. “A ratio like this is unprecedented, including during the tech bubble,” Mike Wilson, the bank’s head of U.S. equity strategy, said in a note Sunday. “Capital concentration is following corporate inequality like never before.”
Inherently, stocks operating in the same industry have a high correlation, and this is also true for the FAAMG stocks. It has been reported that the correlation between these mega tech firms has been growing stronger, and consequently so has the correlation of the S&P 500 to the FAAMG stocks.
It is important for novice investors to understand the relationship and correlation between different stocks, as overexposure to highly correlated assets can be catastrophic for a portfolio, should there be a sharp decline in the stock prices.
Disclaimer: This article was issued by Rowen Bonello, research analyst at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.