Competitive Advantage in Investing. Steven Abrahams

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with unpredictable prices or cash flows will tend to offer relatively high returns. It's intuitive.

      The simple idea of the reliability or variance of returns makes it easier to compare investment returns, including returns on investments that might otherwise seem wildly different. Almost every investment leaves a trail of returns with an average rate of return and variability around that average. An investor can measure variability by a wide set of measures: variance or standard deviation, the ratio of winning days to losing, the largest loss, and so on. They all get at a different facet of risk. A stock or a portfolio of stocks, a bond or a portfolio of bonds, options, real estate, commodities, mutual and hedge funds, and so on all leave a record. All investments leave a trail of returns as distinct as a fingerprint.

      Markowitz's emphasis on risk and return encourages investors to compare investments on these two attributes. An investor could take more risk to get more return. But an investor also could compare investments with roughly the same risk and choose the one with the highest return. An investor alternatively could compare investments with similar returns and choose the one with the lowest risk. And an investor could take a view on the future risk and future return of a menu of investments. Investing suddenly becomes an exercise in trading off risk against return.

      Investors trading off risk against return should transform the relative value of different assets. For assets with roughly the same risk, the one with the highest return would attract more investment. Its price would rise relative to others and its return would fall. Returns across assets in that sleeve of risk would tend to converge. For assets with roughly the same return, the one with the lowest risk would attract investment. Relative prices and returns would start to shift.

Illustration of Markowitz's approach leads to a limited combination of securities that have the highest return for a given a level of risk or the lowest risk for a given level of return.

      Markowitz would have taken an important step if he had only made risk and return equals, but he has another idea that revolutionizes investing: investors can improve risk and return in a portfolio by mixing investments. In other words, investors have something valuable to gain from diversification.

Image described by caption. Graph depicting the expected return of risk in a portfolio falls as the correlation between investments A and B drops from 1 to –1.