Financial Portfolio and the emotional restraints to risk

There is nothing optimal about a financial portfolio of assets, it is just that a trade off exists between risk and return. If you have a higher risk appetite you can create a portfolio with a bunch of risky assets that would entail an expectation of higher return but concurrently have more standard deviation, which is a measure of risk.

Who would have thought that a 400 B.C. invention of parabolic curves by the Greek Mathematician Menaechmus would drive modern Portfolio Theory in Financial Assets?

The complex theory could be simplified into the following postulate that portfolio return and risk are related as like a parabola, you could have the highest return in your chosen portfolio but you could have the biggest risk in form of standard deviation. In fact the reason why such high return happens is because of the high risk premium associated with such portfolio.

Take Equity returns and you will see blue chips returning at double digits and more consistently. But so will be the standard deviation of returns for many others. On the other hand a bond would be returning much lower but the standard deviation of returns will be very low. The reason why investors are willing to buy equities is because the risk premium is high, so the reasoning looks very circular.

Risk averse investors would settle for less risky assets and they have a portfolio return and risk curve the way they choose. But why put all the eggs in one basket? Why have only equities in your portfolio, you could have bonds as well or real estate or a mix of commodities, like Oil for example. The return of your combined portfolio could have a standard deviation that could be lower at the same return levels had you held only a single asset class in your portfolio.

That is the beauty of a parabola, that for the same level of risk you could have two different levels of return, one high and one low. So this is precisely the reason why you should not hold only bonds in your portfolio or only equity and a mix of both could diversify your risk.

But emotions are a different matter and risk and emotions blend in many different ways.

Think of an Oil producer and he will most likely be holding bulk of its portfolio in Oil, continue to hold long positions. Take a Real Estate Investor, her portfolio would be majorly in Real Estate or take a Stock Investor and he will be majorly in Stocks.

Is it possible for Aramco to diversify its portfolio from Oil to other assets? For that matter is there anything optimal in a portfolio and how do the emotions in us play to select one against another?

There is nothing optimal about a portfolio, it is just that a trade off exists between risk and return. If you have a higher risk appetite you can create a portfolio with a bunch of risky assets that would entail an expectation of higher return but concurrently have more standard deviation, which is a measure of risk.

Risk involves uncertainty as well an appetite for such uncertainty and we do not have the same mental attitude to risk taking when it involves gains as well as losses. We become twice let down with a loss than the euphoria we garner for a gain. So we put in twice the mental restraint for making a risky venture to safe-guard against loss.

Samuelson, one of the greatest economists of this century, once asked his friend what value would he assign to heads if a tail would cost him a loss of $1000. The friend assigned two times the value of $1000, which means we assign far higher value to losses than to gains and this is so fundamental to risk taking.

A portfolio of investments is no different, it is like playing this game of tossing a coin ten times, in this case our appetite for risk taking could be better served with multiple possibilities over the repetitive outcomes.

Daniel Kahneman on the other hand provided vital clues on how we provide weights to possibilities and how we could narrowly frame a possibility.

In our encounters with risky events, we are driven by several biases that make our decision- making blurred with weights that sway our mind towards specific decisions.

Inferential Statistics on the other hand is hugely mis-understood, for example Bernoulli's Law of Large Numbers or the concept of Regression to the Mean when applied in the case of repetitive events would make people believe that if an event has happened several times in one specific direction the probability of it happening the other way would increase. It does not increase.

For example if a coin has shown heads 26 times, the odds of the 27th head remains 0.5 and not more than that as each toss is an independent event.

When it is your own money, as an investor how much risk would you take vis-a-vis someone who is your asset manager and he is generally taking risk with other people's money and how much risk will he take? It was found, which is chronicled by Kahneman that individual investors selling stocks to re-invest in other stocks actually ended up with lower return on the stocks they bought than the professional managers who held on to the stock to gain more. The individual investor framed their gains on the value of their purchase (price of buy Vs sell), whereas the professional manager had no such reference to be straddled with.

So when you are selling a stock just because it is much higher than the value when you bought it, your decision is based on pure individual profit whereas the stock that has grown to a higher value is an indication that it is more attractive as a buy and therefore holding it could give you a better value in the future.

Such decision making is never possible if you are your own investment manager, as you would be guided by emotional restraints that make you risk-averse to losses.