modern portfolio theory.

OK, today we’re going to go over some basic investment theory. Wait! Don’t leave yet! I promise, this is interesting. OK I can’t really promise that. But stay with me here and see what you think.
One of the basics of investing is what’s referred to as “Modern Portfolio Theory.” In a nutshell, MPT states that you can reduce the volatility, or risk, of your investments through diversification. If you had $100,000 to invest and you put it all into Apple stock, for example, this is considered risky, because you have all of your eggs in that proverbial one basket. If you took that same $100,000 and bought 10 different stocks of companies in different sectors of the economy, you would be spreading your risk over a broader area. This is considered safer.
Are you with me so far?
Modern Portfolio Theory also states that one’s investments are subject to 2 different kinds of risk – systematic risk and unsystematic risk. Systematic risks are things we can’t necessarily protect against with diversification – they affect everyone, such as recessions, interest rates, etc. Unsystematic risk is risk that’s associated with a particular investment. Like, Apple stock is subject to a different set of risks (tech spending, cost of electronic equipment) than, say, McDonald’s (unemployment, the cost of potatoes).
There is one more piece to MPT, but we’ll get to that another day. OK, so you’re asking yourself, why did she tell me this?
Well just like looking at relationships in the context of tattoos, we could also look at them in the context of investment theory.
Would you say that diversification in relationships is good? Do you prefer to diversify to reduce risk within one relationship, or diversify across several relationships? Should I find a man for each facet of my personality? The most culturally acceptable route is the two-person approach. I could argue that this is definitely “putting all your eggs in one basket” – but most of us find a way to make it work (however don’t get me started on the “buy and hold” approach…). So maybe instead of investing $100,000 in shares of Google, you could invest in an Allocation Fund – one mutual fund that holds many other mutual funds within it. For diversification. You’ve got your Large Cap, Mid Cap, Small Cap, International, REITs (real estate), etc. All in one fund. Well if I could only invest in one thing, this is what I would go with. Someone who has a little of everything I’m looking for. There isn’t one person who will fill ALL your needs, but why not get as close as you can? Maybe if I’m wanting to invest more in Mid Cap, I’ll look for someone who’s more heavily weighted to this area…
You can always scrounge up a few extra bucks to invest in a few other “satellite positions” to fill other needs (friends, co-workers, etc).
As for systematic risk – well that’s never going to go away. There are always those pitfalls that come with dealing with other human beings. But we wouldn’t want it any other way, would we? And unsystematic risk – stick with that allocation fund approach and you reduce it a little… but it’s up to you to make your choices wisely…

At the end of the day, there is always risk, when you are looking for reward, so deal with it. We might be risking a lot sometimes, but the payoff is huge – beyond calculation.

(In the next installment, there will be GRAPHS! Wooooooo!!!!!)


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