< Back to Trader Blog Articles

Modern portfolio theory & the FAAMG Stocks

06744 CC Trader Talk V2

Modern portfolio theory (MPT) was first introduced in the 1950’s by Harry Markowitz. MPT emphases the concept of maximising the return investors could earn in their investment portfolio, bearing in mind a given level of market risk.

The MPT is based on the primary assumption that all investors are risk averse, meaning that investors will only take on more risk if a higher return is expected. Markowitz argued, that the added value of an additional security to a portfolio needs to be measured with its relationship to all the existing securities in a portfolio and that the individual risk of a security is irrelevant, as it is the correlation between securities that will determine the overall risk of the portfolio.

The correlation, which ranges between -1.0 and 1.0, is a statistical calculation that computes the strength of the relationship between the relative movements of two variables. A correlation of 1.0 indicates perfectly correlated assets, a correlation of 0 indicates that there is no association between two variables and a correlation of -1.0 indicates perfectly negatively correlated assets. This means that, in a hypothetical two-asset portfolio the total risk of the portfolio will be lower than the aggregate risk of the individual assets, as long as the correlation of the securities is lower than 1.0.

The process of identifying assets with a low correlation under the MPT, lessens the specific or idiosyncratic risk inherent in each investment, with most diversification benefits achieved at approximately 30 assets. All possible combinations of risky asset portfolios are constructed to identify those portfolios with the highest return for any given level of risk. The set of these portfolios is collectively referred to as the Markowitz efficient frontier.

It is important to note that risk can never be completely eliminated, as systematic risk (also referred to as market risk) is always present. Market risks are risks that can disturb the economic market in general or a large portion of it.

Where do the FAAMG stocks come into play?

The FAAMG is an abbreviation for the top-performing tech stocks in the US market, being, Facebook, Amazon, Apple, Microsoft and Alphabet’s Google. It’s no surprise that these tech giants have dominated the market, with Apple and Microsoft surging by 86% and 55% in 2019, respectively.

The FAAMG stocks now make up a whopping 17.3% of the total market capitalisation of the S&P 500, with Apple representing 4.8%, Microsoft 4.6%, Alphabet 3.2%, Amazon 2.9% and Facebook 1.9% (data as at 10 January 2020). This rising concentration risk is raising concern between market participants and this ties in with the correlation concept mentioned above. “A ratio like this is unprecedented, including during the tech bubble,” Mike Wilson, the bank’s head of U.S. equity strategy, said in a note Sunday. “Capital concentration is following corporate inequality like never before.”

Inherently, stocks operating in the same industry have a high correlation, and this is also true for the FAAMG stocks. It has been reported that the correlation between these mega tech firms has been growing stronger, and consequently so has the correlation of the S&P 500 to the FAAMG stocks.

It is important for novice investors to understand the relationship and correlation between different stocks, as overexposure to highly correlated assets can be catastrophic for a portfolio, should there be a sharp decline in the stock prices.

The Calamatta Cuschieri Traders Blog is available daily on CC WebTrader. Other market coverage including coverage of the International Bond Markets is also available.

Important(Notices)
The information provided on this website is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Similarly any views or opinions expressed on this website are not intended and should not be construed as being investment, tax or legal advice or recommendations. Investment advice should always be based on the particular circumstances of the person to whom it is directed, which circumstances have not been taken into consideration by the persons expressing the views or opinions appearing on this website. Calamatta Cuschieri & Co. Ltd. (CC) has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website. You should always take professional investment advice in connection with, or independently research and verify, any information that you find or views or opinions which you read on our website and wish to rely upon, whether for the purpose of making an investment decision or otherwise. CC does not accept liability for losses suffered by persons as a result of information, views or opinions appearing on this website.
This website is owned and operated by Calamatta Cuschieri & Co. Ltd (Co. Reg. No. C13729) of 5th Floor, Valletta Buildings, South Street, Valletta VLT 1103, Malta. CC is licensed to conduct Investment Services in Malta by the Malta Financial Services Authority.