Economist Harry Markowitz received the Nobel Memorial Prize in Economic Sciences for his seminal work in establishing the Modern Portfolio Theory (“MPT”) in 1990.  MPT relates to maximizing the return investors could obtain in their investment portfolios when considering the underlying risk involved in the investments.  Investors evaluate the risk of one investment in relation to impacting the entire portfolio. MPT attempts to eliminate “idiosyncratic risk” – the risk inherent in each investment due to the investment’s unique characteristics.

According to Markowitz, investors could create a portfolio maximizing returns by accepting a quantifiable amount of risk.  This is accomplished when investors diversify their assets and asset allocation using a quantitative method. With a portfolio as such, if some assets fall in value due to market conditions, other securities should rise equally in compensation. Markowitz demonstrated that, by taking a portfolio as its whole, it was less volatile than the total sum of its parts.  Basically, do not keep all one’s eggs in the same basket.

Time and time again, the MPT has proven itself and is a basic investment strategy among financial advisors.
This past Monday, the price of oil had its most significant one-day decline since the Gulf War of 1991, plummeting by more than 30 percent. This devastation only contributed to many oil-rich states that already had a miserable 2020 start. A barrel of oil now costs half of what it did at the beginning of the year.
The success of the MPT would have limit losses in the events occurring this week.  The MPT was explicitly designed to prevent losses from an event such as this week’s oil fiasco.

As it turns out, many investors were concentrated not only in specific oil stocks but in the oil sector, causing significant and avoidable losses.  When stocks do not trade inversely with each other or move simultaneously together, there is no diversification, and the MPT is being ignored.

Why would a stockbroker or financial advisor disregard prudence and concentrate an investor’s portfolio in oil?  There are many reasons, including but not limited to, generating commissions, negligence, and putting the brokerage firm’s interests over investors.  The list could be long.

In any event, investors have legal recourse and may recover losses due to complete disregard for limiting portfolio risk.  If you have sustained losses due to being concentrated in specific security or sector, such as the oil industry, do not hesitate to contact the Law Offices of David Harrison for a consultation.

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