Setting the context: In this article, let’s delve into the history of Portfolio Management. We will explore the different theories which etched their mark in the domain of portfolio management.
Theory 1 – Dow Theory
Charles Dow the ex-editor of the Wall Street Journal, presented his theory on the influences on Stock Market movements. His theory states that, the stock market is influenced by 3 main factors, namely:
- Primary Movements: Long-term factors which sway the markets.
- Secondary Reactions: As the name suggests are the reactionary forces driven by people and institutions in response to the ongoing market events. These reactions are short-lived.
- Minor Movements: These are the intraday movements observed in the markets and do not have any informational significance but rather are transitory in nature.
Dow’s Theory provided the technical framework to view the stock market and understand the current business environment. According to him by analysing the overall market and the prevailing conditions one could predict the direction of the market and the individual stocks. His views now form the core of modern technical analysis.
Theory II – Efficient Market Hypothesis
The Efficient Market Hypothesis states that the current stock prices reflect all the available information. According to this theory, since the stock prices already reflect everything there is to know in the market, no investor can gain an edge over the collective market. Therefore, there is no methodology to outperform the market as such, by any individual investor. Proponents of the Efficient Market Hypothesis believe in the passive form of investing (like buy-and-hold strategy, indexing, etc) whereas those who oppose it are proponents of Active Investing.
Theory III – Modern Portfolio Theory
The Modern Portfolio Theory (MPT) introduced by Harry Markowitz through his paper in 1952, was widely acclaimed and even deemed Noble-Prize worthy! The MPT provides a mathematical framework for constructing portfolios which can maximise return for a given level of risk. The essence of the theory is that, an investment or a security should not be viewed singularly but rather from the lens of how it would impact the risk and return characteristics of a portfolio. Modern Portfolio Theory can be viewed as the formalisation of diversification in investing.
And that’s a wrap for this week! Stay tuned for new articles every week, simplifying Finance for Gen A to Z.
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