Modern portfolio theory and diversification

This is not investment advice. I am not a financial adviser. These are my opinions based on my research.

Modern portfolio theory

A major insight provided by MPT is that an investment's risk and return characteristics should not be viewed alone, but should be evaluated by how the investment affects the overall portfolio's risk and return.

How much diversification is enough? Research indicates between 20-30 stocks is the optimal amount. Ideally this list has to be the best most curated list you can create across many sectors and regions. There can be too much or too little diversification but really how much confidence you have in a company can be used to determine how much money to put into buying the stock.

The equations to remember for modern portfolio theory:

The expected return of the portfolio is calculated as a weighted sum of the individual assets' returns. If a portfolio contained four equally-weighted assets with expected returns of 4, 6, 10 and 14%, the portfolio's expected return would be:

(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%

The portfolio's risk is a complicated function of the variances of each asset and the correlations of each pair of assets. To calculate the risk of a four-asset portfolio, an investor needs each of the four assets' variances and six correlation values, since there are six possible two-asset combinations with four assets. Because of the asset correlations, the total portfolio risk, or standard deviation, is lower than what would be calculated by a weighted sum.

Modern portfolio theory highlights that it's important to focus on growth of the portfolio and the equations helps with measuring that. These equations calculate risk as well and for this reason it is in my opinion possible to create a bot or portfolio generator which can theoretically populate a stock portfolio based entirely on equations. Risk and expected performance can be measured on an X and Y axis allowing for what is called an efficient frontier.

This online tool allows for the calculation of efficient frontier above. There are also other tools available but this is an interesting tool to play with to learn these concepts. The interesting thing to note is that dividend paying stocks may also offer tax benefits. So if a strong portfolio is assembled then holding for as long as possible defers the capital gains taxes one would acquire from selling which means the ideal to avoid paying maximum taxes is to buy and hold for the long term while spending the dividends. Dividend taxes are much lower than income taxes dollar for dollar as well which is optimal at least from my perspective for tax efficiently. Again not being a financial advisor or an accountant I would not know and better to seek professional advice before you try any of this.

Dividends also generate cash flow. But of course interesting stuff is happening with treasury bonds. Yield from bonds may reach 4% or higher which could make bonds more attractive than stocks. Margin of safety is critical to stocks but with bonds, what can be more safe than treasury bonds? Price to earnings ratio can tell you when to sell a stock (over 40 may be a good signal the stock is over bought and time to sell while under 20 could signal it's under bought and under valued).

References

1. https://www.investopedia.com/terms/e/efficientfrontier.asp
2. https://www.investopedia.com/terms/p/pmpt.asp
3. https://www.cnbc.com/2018/02/14/us-treasury-yield-climb-may-be-due-to-failing-bond-auctions.html