A lot of retail investors struggle to stick to an investment strategy for their ISA. Having a strategy is not just for large mutual fund managers – it will almost certainly help you to generate better returns.
Now you may pursue a strategy regarding income, aiming to pick up dividends from the businesses you invest in. Or you may aim for pure share price appreciation, by buying low and selling high. Irrespective of aim, all investors want to try and minimise the risk they take and maximise the reward they receive while keeping the funds within the tax-free ISA wrapper.
To that end, Professor Markowitz devised a modern portfolio theory known as the ‘efficient market frontier’, which everyday investors such as you and I can use in order to ensure that we have a sound strategy to boost our returns.
What is the modern portfolio theory?
In short, Markowitz argues that a line can be charted on a graph, showing expected return on one side and volatility on the other. We can think of the expected return as our reward as stock investors, and volatility as the risk. After all, few of us would argue that high volatility equals low risk – just take a look at Bitcoin as an example!
Now if you want 0% volatility, or super low risk, then your line on the return axis will be around 1%. This would be like putting all your funds into a Cash ISA. On the other end of the line (known by academics as the market frontier) you could have 100% invested in stocks. While this would have earned you a return of around 12% last year (based on the FTSE 100), you would have taken on a lot more risk.
The theory recommends that investors like you and me need to be somewhere on the line, on the efficient market frontier, in order to maximise our risk/reward. If you have a stock with a variance (a gauge of volatility) of 15%, but are only getting a 1% return over the past year, then the theory states this is not the best strategy. Why? Well you could simply put the funds into a Cash ISA and earn the same return but with almost no risk.
How can I apply the investing strategy?
Firstly, holding just a few stocks is not the best way to invest. You can reduce risk (volatility) by investing in the broader market and diversifying, something we bang on a lot about at the Motley Fool. By buying a mix of stocks from different sectors, industries and sizes, you can reduce firm-specific risk while not materially bringing down your reward (potential share price appreciation).
Further, the efficient market frontier does not have to be a straight line. Thus, you can often achieve a much higher reward by taking on a little more risk at the low end of the graph. For example, you do not have to take on much more risk by trying to achieve a 2% return versus a 1% return. This is one reason why I prefer to invest in stocks versus leaving my funds in a Cash ISA.