How investors have changed their approach to capital management in the stock market over the past 100 years.
Influenced by the fundamental works of leading economists and technical progress, market participants have followed a winding path so that now each market participant can build a profitable portfolio that fully meets all of the investor’s needs according to Modern Portfolio Theory (MPT).
It is hard to imagine today, but at the beginning of the last century, investors used to have heated arguments about which is more profitable: stocks or bonds? Many investors even considered stocks to be “junk bonds”. Nowadays, having all the opportunities of the modern market at one’s fingertips, those earlier conditions were the equivalent of the “financial middle ages.”
The first mutual fund «The Massachusetts Investors Trust» is launched in the United States. Investors realize that collective investment allows them to profit from the assets that were previously too expensive for them individually and that wide diversification reduces their risks.
John Williams proposed The Theory of Investment Value. Armed with it, investors were able to reliably evaluate companies through their earnings and, consequently, the fair value of their shares.
Harry Markowitz publishes his famous paper «Portfolio Selection» where for the first time he describes risk mathematically and proposes a mathematical way of calculating asset allocation within a portfolio. The extreme value of these ideas is hard to overstate as they have revolutionized the strategy used by portfolio managers. Markowitz discovered the synergistic effect of different asset classes with low correlation within the same portfolio.
Based on the works of Markowitz, William Sharpe develops the Capital Asset Pricing Model (CAPM) that raises the portfolio risk assessment and forecasting future returns to new heights.
Eugene Fama proposes the Efficient Market Hypothesis (EMH). He says that due to the efficiency of communication tools, news instantly spreads among market participants and gets reflected in asset prices immediately. This closes windows of opportunity for active speculators who capitalize on temporary market inefficiencies. If we take this factor into account, add in the commissions and taxes resulting from frequent trading, it becomes quite clear why 80% of active speculators and managers lose out to the broad market index over a five-year period.
G. Brinson, R. Hood, and G. Beebower publish their research called Determinants of Portfolio Performance. They studied the results of the 90 largest US pension funds to determine why they were different. It turns out that in 94% of cases, success was based on the relative proportions of the stocks, bonds, and cash assets, and only in 6% of other cases the profitability depended on the choice of specific stocks, entry points, and costs.
The first ETF (Exchange Traded Fund), SPDR S&P 500, is launched in the US. In a short time, the number of ETFs increases to several thousand, which makes them an indispensable tool in the arsenal of a modern portfolio manager.