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 verage, 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.