An ocean of literature concerning the construction and deconstruction of a market portfolio to achieve outstanding returns is limitless and readily available on the internet. An argument presented is that the internet has most certainly democratized information and its availability. Individuals can listen and grasp information from some of the world’s brightest minds, providing avenues of guidance for investors to seek positive directions and imparting positive principles along the way. A consistent theme emerges from their oration or publications; investing is a risky proposition. Investing relies on a certain level of conviction, control, and application. Even with limited financial knowledge and expertise, returns in the market for a long-term approach can be linear to construct. Introductory algebra like addition, subtraction, multiplication, and division can serve as the thesis in fabricating a linear market portfolio.
To refresh your history on algebra’s origins, view the presentation made by Mr. Khan from KhanAcademy.org. The video helps illustrate the breadth of history that correlates to the various theories that govern algebra. While no approach reigns supreme, sometimes keeping it simple is just less stressful. By that, a mastery of the basics: addition, subtraction, multiplication, and division can serve as the foundation to create a portfolio. Investing is nothing more than an algebraic equation with variables looking to explain or retrieve a solution.
x ± y = z
(where x is an investment, y is total gain/loss, and z is market value) [Eq.1]
[Eq.1] serves as a good starting point for understanding how investing works. It implies that when cash is invested in a commodity, its intrinsic price shifts from its initial standing to its associated market price after total gain/loss is added or subtracted. In an attempt to throw off the numerophobes and arithmophobes, let’s add one more variable to the equation – ‘a’.
y = x * (a)
(where ‘a‘ is the % change of market price of commodity) [Eq.2]
Substituting Eq.2 into Eq.1
x ± (x * a) = z
Investment + (Investment*Total Gain/Loss) =
Market Value Of Investment
We shall call the above equation [Eq.4]
The above equations are best explained with a situation. Introducing, Tina. Tina is probably someone you know, someone you are friends with, and Tina has decided to invest some money to secure her future. Tina chose to invest in gold. She decided to invest $500 towards gold, a safe and secure commodity. She was available to purchase 10 grams of gold since the principal value, 1 gram of gold, was worth $50. Her investment’s market value would be $500 if applied to [Eq.4], assuming that the price is steady and no loss or gain of principal value has occurred at the moment of purchase. As time moves on, so do the markets, and Tina later learns that the price of gold is now $75 per gram. That is a 50% increase in the market value of gold for every gram. Tina decides to assess the market value using [Eq.4] and finds that the market value is $750 now. Tina did not rely on some high-level calculus or trigonometry to interpret the market value of her investment. She chose simple tools like addition, subtraction, multiplication, and division, to invest and render a judgment of whether an investment is working favorably or not. With time, Tina enjoys investing in the future and adds to her collection of assets. She purchases some stocks, treasury bonds, and other commodities and realizes that what she has in her hand is a portfolio. A portfolio that is a reflection of her financial standing and desires.
A collection of [Eq.4] will represent the total portfolio. Like the slices of an extra-large pizza or the pieces of a jigsaw puzzle, individual investments conform together to mature a portfolio. Popular literature speaks to the value of diversification as insurance from the evils of the market. Diversification allows the participant to involve their investments in various investment vehicles instead of purely relying on one medium. There is value for specialization, but to achieve discipline in a defined field is a gargantuan feat. Markets are non-conformational and dynamic. Instead of rendering expert judgment on the construction of a portfolio based on limited market exposure, algebra can serve as the basis for the Marketrama Portfolio Theory’s foundation.
Our theory starts with a principal amount, represented by ‘n’, where n=$1000. Now to keep things simple, we shall use whole numbers and reintroduce Tina. Tina decides to invest in stocks, bonds, and gold (her favorite from the previous example). To keep it simple, she decides to breakdown the pie into 30%, 30%, and 40%, respectively. According to those percentage breakdowns, $300 goes to stocks, $300 goes to bonds, and $400 goes to gold. In this example, to buy an article of stock or bond or gold, the price is $10. At that market price, Tina receives 30,30 and 40 units of stocks, bonds, and gold, respectively. As time moves on, so does the market, and Tina learns that the price of one unit of stock is $25, one unit of bond is $12, and one unit of gold is $15. Using [Eq.4], we learn that,
Current Market Value of Stocks=$750
Current Market Value of Bonds=$360
Current Market Value of Gold=$450
Total Market Value of Portfolio=$1560
If Tina elected to isolate her investment to gold and invest the entire principal amount to gold, she would have received a total of 100 units of gold at the initial value of $10 a unit. With the value of 1 unit of gold at $15, Tina’s portfolio’s market value would be $1500. With diversification, Tina achieved a $60 gain in returns compared to without diversification. These numbers are hypothetical but reflect a larger point of view that while diversification can sometimes allow for extraneous exposure, a similar outcome can be generated if an apt combination is acquired. Instead of the clean 30,30,40 split, if Tina would have opted for 60% stocks, 20% bonds, and 20% gold, the market value of her portfolio would be
Current Market Value of Stocks=$1500
Current Market Value of Bonds=$240
Current Market Value of Gold=$300
Total Market Value of Portfolio=$2040
A variety of allocation structures can lead to a myriad of returns. The allocation structures should primarily speak to one’s current financial standing and interests. No one combination is supreme, and returns are not guaranteed. As with the examples above, the scenarios and numbers presented are hypothetical and are purely used to convey a point. No two market instruments are similar, and an individual must conduct their due diligence before investing in any market instrument.
A litany of literature exists on constructing a proper portfolio, with some professionals suggesting that there should not be more than 5% of exposure in a particular sector or domain. The lecture, Portfolio Management provided by MIT OpenCourseWare is an excellent lecture to listen to understand the specifics and nuances of constructing and managing a portfolio. The video does share technical lingo but is a great tool to draw inspiration and learn the concepts. Another resource worth mentioning to draw inspiration from is Beavers. Like the dams they create, this industrious native North American builder can build dams as high as 5.5m, which can develop ponds “deep enough not to freeze the bottom, providing storage for winter food and year-round underwater access to the lodge secure from predators” .
Having foresight like the beavers is essential since reckless abandon can lead to unnecessary damage and disappointment.