What is Portfolio Strategy

Portfolio strategy is a theory developed by a Harry Markowitz. In general it allows to estimate expected returns on investments and risks. Thanks to statistical tools this theory enables combining a perfect portfolio of investments and thus optimize the mid-term and long-term incomes.

The basic mechanism used to achieve the best investment results in portfolio strategy is diversification optimization - the investments should be combined from assets with dissimilar movements of price. For instance – if one has an option to invest in asset A which can grow 10% and fall 5% in a set period of time or to invest in asset B which will grow 10% when asset A price falls and fall 5% when asset A price rises, it is best to invest in both of them simultaneously. Why?

Let’s do some mathematics. If we invest 50% of our money in asset A and 50% in asset B, we will have 100% guaranteed return of 5% per each period of time. Thus, in let’s say 4 time periods we will achieve approx 21,6% return. On the other hand, if we invest 100% of our money in one of the assets, we can get a 50% chance of 10% return in each period of time and 50% chance of 5% capital decrease. Assuming we get 2 years of 10% return and 2 years of fall, we will achieve total 9,2% return on investment. Of course this is a big simplification and in real world we would never find assets perfectly oppositely correlated (or in other words with correlation value of -1), neither the investments have exact 50% chance of falling or rising. Nonetheless portfolio theory has proved to be working perfectly in practice, as long as the input data is correct.

The best conclusion that comes from this theory is that diversification is the basis of every optimal investment portfolio. The best results are achieved when the assets we hold are correlated oppositely, as for instance are businesses of umbrellas manufacturers and producers of sun glasses. One has to remember however, that capital markets are very complex and precise estimation of the correlation level is impossible, as well as there are no perfect correlations, since in mid and long-term, if the economy is down, everyone loses.

Henry Grean