A friend of mine went to the stock market the other day and came back saying that judging by the number of people that he met at the exchange that day, there seem to be a lot of people who are packing their suitcases these days to go on some vacation somewhere than there are minding their investments. But that was just an assumption. At any rate, I don’t think we can blame anybody if they want to stay as far away from financial risks as they can these days.
Anyway, if we are going to some unfamiliar places for a vacation, we need to have at least an understanding of the places we are going to visit if we want to be safe, right? And we are going to want to have that knowledge before, not after, we get there, right?
Well, that is the same thing in investing. And that is what we are trying to do here – to arm the future investors with even just a little bit of knowledge about investing, so that at least they would know what in the world is going on, should they ever feel lost along the way.
We have already mentioned in previous posts that there is such a thing as Modern Portfolio Theory (MPT). In that theory, there are a lot of terms with fancy names like “negative covariance” and “negative correlation,” etc. that could make our head spin.
But if we try to peel off the high sounding terminologies and look at them without those swanky titles the words actually begin to make sense. If we change the moniker of those two (negative covariance and negative correlation) for example in the realm of investing, they would simply refer to stocks or assets that are moving in opposite directions.To illustrate using stock A and stock B: If those two stocks are positively correlated they will move in exactly the same direction. If A is going up, B is also going up. If they are negatively correlated: A would be going up if B is going down and vice versa.
To avoid getting confused, let’s do our best to forget those terms with elegant titles for the time being (unless you are more comfortable using those terms) and just concentrate on remembering the stocks or assets that are moving in opposite ways.
Markowitz, the author of the Modern Portfolio Theory, believes that to minimize our losses in our investments we need to have assets that move in opposite directions.
To answer, let us imagine that we have four (4) twenty five centavo coins (quarters) in our pocket. Let us also imagine that economic crisis is a natural occurrence and that every time it happens, all the coins in our pocket that move in the same direction will fall into the floor and disappear. Now, if all of our four coins are stocks, and they are all moving in the same direction, they will all fall into the floor (lose value) during an economic crisis.
Following this line of thought, if only three of them move in the same direction, you will have one coin left in your pocket, right? Well, then, you have minimized your losses -simple right?
Let us try to simplify this some more by calling that coin that moved in the opposite direction as “dissenter.”
In good times, when the coins that move in the same direction are going up, the dissenter will give us some problems by reducing the amount of profits we are making, right? This is because it moves down while the other coins are going up. But conversely, in bad times, it will give us some relief because while the rest of the coins are giving us losses the dissenter is earning us a little money, right?
If this is already clear to you, let’s move on to the discussion of the theory in modern portfolio and see how the dissenter can help us during economic crisis, because no matter what we say, if only one out of our four assets are making us money and the three others are bleeding our pockets, we are still losing money, right?
Well, what will really help us in this process is our developed ability to spot those dissenters. That is the reason why we need to be good at identifying them. The fact that we do not know exactly when a crisis is going to hit the economy (and spill all the coins in out pockets) is the reason why we need those dissenters in our portfolio. Not necessarily to lessen our profits during good times but to act as cushion during the bad times.
But how can those dissenters make us money, instead of just “save” us money?
Come on! Don’t tell me you still haven’t figured that one out yet.
Anyway, you can actually reverse the process and see if you can get more of those “dissenters” during economic crisis – then you get your profits.
Many will go for another strategy baptized with another elegant title called “Hedge” but I wouldn’t do it that way if it would be as damaging to most of us – as oil is these days.
LIKE WHAT YOU’VE READ?
If so, please join over 5,000 people who receive exclusive biweekly online business and blogging tips. I promise I promise you won’t regret it!