How I entered the markets through Modern Portfolio Theory

My laptop screen looked back at me and displayed four options: Companies management, Nuclear energy, Hydrogen systems or Electric vehicles. I had to choose one of those to fill my college semester. I like the concept of nuclear energy and would like to know more about the amount of energy required to fission the atom, how a single atom is separated or if it isn’t and the economics of it. Sadly, no one else is taking this class (not much job potential for nuclear in Portugal) so this is a ghost option. Hydrogen systems is my second choice. From what I’d read so far, hydrogen is a viable solution to counter gasoline. Interesting, I want to know more. Well, I hear this class is without a teacher and can’t be chosen. Another ghost option. Ok, ok, then electric vehicles. I’d like a lot to know whether DC motors, induction motors or synchronous motors are used. And if one is used more than the others, the reason for it. How are the protections setup inside an electric car? Are they similar to a house’s electric panel? Probably not, but it’d be nice to know. Well, fuck, that class is full. Damn it! Ok, relax, Companies management might be not so boring and useless as its name implies.

I chose my forth option and I’ll kill the suspense right away. It was a useless, misleading and stupid class that brought nothing more than headaches and robbed me time. It was supposed to be a simple and quick class to take, but its teachers gave it a twist and I almost flunked.

What was this class about? Employee management? Inventory storage? Tactics to improve business? No, my dear… It was solely about the stock market, namely Modern Portfolio Theory. How is that even remotely related to companies management I’ll never know. Damn that misleading name. It should be called ‘Modern Portfolio Theory teached in a way that the student has to go find the information and the teacher merely pretends to be busy’.

It is funny how every decision we make ultimately takes us somewhere we didn’t envision before. I didn’t like this class, but it sowed in me a curiosity about MPT. I liked its concept of characterizing volatility as risk and past returns as signals of future ones. The idea that owning Pepsi and Coke is bad due to its correlation came as an enlightened conclusion to me. Of course it’s bad, if they are correlated then they are the same, if they are the same and react the same way then I should decide and own just one. If not, I compromise diversification of risk. Of course.

I liked what it promised, to minimize risk and maintain returns just by balancing the portfolio percentages. Oh, those big-heads I read about daily must be simply applying MPT. I could do it also. I’ll just create an excel that calculates correlation between stocks, data mines past returns and past volatility and voilà, I’ll be an investor.

As any over-eager 20s student, I dived with my head and obsessively observed stocks. I wasn’t interested in any given stock (or for that matter in its issuing company), I was interested in creating an uncorrelated, unrisky and mega-return portfolio. Simple enough, although a little more time consuming than I initially thought. What about Coke? It had a nice return, not much volatility. So, what is uncorrelated with Coke? Carmakers? Nah, people drive to convenience stores to drink, people drive while drinking. I want Coke to be on Earth and another stock that is on Mars. Oil companies? Too risky. Food companies? Too correlated. Biopharma? I don’t understand any of it. Internet? Risky, great returns, uncorrelated. I mean, if a car is correlated to Coke, then computers are like a bubbly extension of the syrup. Even though it’s clear now, back then I saw a winning combination in Coke+Microsoft.

Did I know any of the companies beyond its brands? Zero. In the end I didn’t start investing using MPT. By the time I did, I had already discarded MPT as being too certain of its equations and not giving any guidance on how to evaluate a company. It was however, a great introduction to the study of the stock market.

A nice tool that I came upon recently that applies MPT is It doesn’t return the data behind each stock and the portfolio chosen (volatility, return and correlation), and its database of stocks is limited (doesn’t have General Motors). What it does is simply choose the percentage that each stock should have in the portfolio. Would I ever blindly take its advice on how to allocate weights? No. It is kind of pleasing to the eye though.

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