Against the Gods
Through all the years of stocks, people never thought of defining risk with
numbers. It was never about a definition, but about the feeling in your gut when
you see that your risk was rising. In the world of Stocks there are two types of
people; the ones who stand by risk and the ones who lean on security. The
aggressive and the faint-hearted. The young man, who separated these, weak from
strong, wrote an article in June 1952, to the Journal of Finance. This man,
Harry Markowitz, an unknown 25-year-old graduate student at the University of
Chicago, wrote a fourteen-page article titled Portfolio Selection.
Markowitz was dealing with a subject considered too dicey and speculative for
sober academic analysis. He was writing for the big boys.
Immediately Markowitz decisively pinpoints his objectives, stating that an
investor should not select securities based on their individual properties, but
based on how they fit into the whole of the portfolio. In other words, the
risk of a prospective security is irrelevant to the investment decision, it is
only the degree to which the addition of this security raises the risk of the
portfolio as a whole that should be considered. This is an important
perspective, since it is quite possible for an extremely unpredictable security
to add very little risk to a portfolio when it is “uncorrelated” with
the securities already in the portfolio. In other words, since the individual
securities do not move together, some of the movement of each is “washed
out” by the movement of the others. These happenings are very unreliable to
predict and nowhere near able to control. Stocks, bonds, saving accounts, and
each investors returns depend on this, risk. However they are still able to
manage the risks that they take. The higher the risk should in time produce more
wealth, but only for the patient investors who can stand the heat.
Risk was the notation that Markowitz used to construct portfolios for
investors who consider expected return a desirable thing and variance of
return an undesirable thing. The and is the hinge on which return and
variance helps Markowitz build his case. He has decided therefore that risk and
variance have become synonyms. This then brings us to variance and standard
deviation. The greater the variance or the standard deviation around the
average, the less the average return will signify about what the outcome is
likely to be. The market is always unpredictable, this is why investors take
the easy way out and only bet a small bit than bet a larger bit and win more.
They know that they are also capable of losing the larger bit as easily as
losing the smaller bit. In von Neumanns game of strategy, he says that by
diversifying instead of striving for the kill the investor at least maximizes
the probability of survival.
Efficiency means maximizing output relative to input, or minimizing input
relative to output. Markowitz rather reserves the term efficient for
portfolios that combine the best holdings at the price with the least of the
variance. But what it really means or what we really want to hear is that
efficient portfolios minimize that undesirable thing called variance while
simultaneously maximizing that desirable thing called getting rich. Its
too bad it isnt that easy. Efficiency is the only loophole in Markowitzs
article that has to be encouraged by the investors gut feeling.
The stock market is a game. Its a strategic game that has to be played
knowingly. The market isnt just a sport that you can manipulate and win
millions on your first try. Its a way of life. A religion to some. These some
know what gut wrenching risk is. Its a risk of numbers. An art, which is
followed by each stroke of the brush. A risk of life. A rush that you get when
youre hurtling down a roller coaster at top speeds. Its a feeling of
superiority. Its the smell of sweat, cologne, leather briefcases and freshly
pressed business suits. Its a whole other world. A utopia. Everything relies
on its turnout. In our daily lives the Stock Market is God.
