3 Investment
Investing is the allocation of money in the expectation of a return. People invest because investing can help to smooth consumption, or it can increase their consumption relative to other options such as saving.
If you have studied economics, you will likely have come across the term “investment”. In macroeconomics, investment is taken to mean the purchase of fixed investments such as structures and equipment by firms, new residential investment by households and landlords, and changes in business inventories. Investment builds the capital stock. This macroeconomic definition does not include the exchange of residences or financial transactions such as purchasing stocks or placing income in a mutual fund.
In this course, I will be using a broader definition of investment. I will take investing to mean any allocation of money in expectation of a return.
3.1 Risk-return trade-off
Investing typically involves risk. When a person invests, they often do not know the exact return they will receive. They might know the mean and variance of the returns, and in economic analysis this is often assumed to be the case. But they might not even know those.
As for most economic actors, investors are typically assumed to be risk averse. As a result, they require compensation in the form of higher returns for taking on risk. The greater the risk, the greater the return required.
Before investing in an asset, the investor will want to know the expected future return and future variance in returns. This is, of course, not observable. As a result, it is typical to estimate them from historical data. This can give the investor data points, such as the mean return and sample variance or standard deviation, which enables them to assess the risk-return trade-off (at least in an idealised world).
3.2 Portfolios and diversification
People often hold portfolios comprising many assets. In this case, the risk of the portfolio is not a simple average of the portfolio assets. The act of placing assets in a portfolio has the effect of eliminating some of the variability. This holding of multiple assets to reduce variability is known as diversification.
Malkiel (2020) provides an example of how this works in A Random Walk Down Wall Street, which I have summarised as follows:
An investor in an island economy has two options: a resort and an umbrella manufacturer. In sunny weather the resort earns a 50% return while the umbrella manufacturer loses 25%. In wet weather, the umbrella manufacturer delivers a 50% return, while the resort loses 25%. There is a 50:50 chance that each season will be sunny or rainy.
An investor in the resort would make 50% half the time and lose 25% half the time, giving an average return of 12.5%. Similarly, the umbrella manufacturer will deliver an average return of 12.5%, but with considerable volatility between the 50% gains and 25% losses. However, if the investor puts half their money in the resort and half in the umbrella manufacturer, they will earn 12.5% every season with no volatility. They have effectively eliminated risk while maintaining the same return.
This is an extreme example of the benefits of diversification, with the fortunes of the two business negatively correlated. However, to the extent there is any lack of parallelism in the fortunes of investment options, diversification can reduce risk.
This concept underlies modern portfolio theory, which tells investors how to achieve optimal diversification by determining the portfolio that can provide the desired return with the least risk possible. As Harry Markowitz, the founder of modern portfolio theory, is claimed to have said (although I cannot find a source), diversification is “the only free lunch in finance”.