99. Does a "diversified stock portfolio" guarantees returns?

 Harry Markowitz: Creator of Modern Portfolio Theory (investopedia.com)

There are hundreds of stocks listed in the Philippine Stock Exhange, if you are to design a well-diversified portfolio, which stocks will be select?

Diversification is the idea that not all securities will move in the same direction at the same time as each stock will be affected individually by changes in market conditions. For example, the OPEC announced a hefty price increase in the price of crude oil, among the listed companies - oil companies may benefit from this and see their stock price rise while companies dependent on oil like transport companies may see their operating margins shrink leading to lower stock price. By combining these two companies in a portfolio, the price drop of transport may be balanced off by the increase of oil companies' stock price.

A portfolio is a collection of assets (stocks) created by the investor intended to transfer the "purchasing power" of excess funds into the future.

Investors can design a portfolio made up of these individual stocks so that the overall return of the portfolio will be more predictable. 

The "Modern Portfolio Theory" was first published in 1952, it was discussed more extensively in the Markowitz's book "Portfolio Selection" in 1959. Here are some key ideas.

Portfolio design can be reduced to two dimensions - First is the expected return and its risk (as measured by the probability that it may not deliver the expected return - it's variance)

The risk of each stock that really matters is not the risk of the stock by itself rather its contribution to the risk of the aggregate portfolio.

With this insight, Markowitz was able to reduce the complicated and multi-dimensional problem of portfolio construction. From an investor's perspective, the more assurance that actual returns will parallel expected returns, the better!

The objective will be a portfolio with the highest expected return with the lowest variance.

Data needed are: 1. the estimated expected return of each individual stock and 2. the variance of its return and 3. the co-variance of the stock returns in relation with other stocks in the portfolio.

Diversification: Why Not Put Everything in Whatever Will Go Up the Most? – Marotta On Money

While a diversified portfolio is no guarantee of future returns, it increases the sense of comfort for investors that the actual return will not deviate too much from the expected return.

All the best my friends!

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