If you were to develop the ‘perfect investment’ portfolio
you would probably want shares that have a high return coupled with a low risk,
of course in reality that kind of investment is virtually impossible to
find. Not surprisingly, academics have
spent a lot of time developing strategies to find the ‘perfect investment’,
none of which have been as popular as Modern Portfolio Theory. Developed by Harry Markowitz in 1952, he explains
that it’s not enough to look at the risk and return of one stock but rather
that by investing in more than one stock you can you benefit from
diversification and reduce the riskiness of your portfolio, in other words.. don’t
put all your eggs in one basket! Each stock has its own standard deviation from
the mean, which modern portfolio theory calls risk, the risk in a portfolio of
diverse stocks will be less that the risk of holding any one of the individual
stocks. In other words Markowitz
proposed that investment isn’t about picking stocks but rather choosing the
right combination of stocks.
The combination of shares can be plotted in a graph
resulting in what is known as the efficient frontier, a portfolio which lies in
the upper part of the curve is efficient and it is argued that a ‘rational’
investor will only ever hold a portfolio that lies somewhere on the efficient frontier.
It seems like the perfect way to always ensure you make money doesn’t it?
However there is one main cause of concern in portfolio theory I would like to
discuss, the notion of a ‘risk free rate’.
In theory a risk free rate is the idea that you would lend
money to a very secure borrower with a 0% possibility they would default on the
loan, in most markets it is the local government bond that constitutes a risk
free rate (The Economist, 2014). Here
lies a problem that has arisen due to the economic recession.. What happens
when a government, like Greece has little hope of ever repaying its debts at
market rates?
In 2009 Moody’s rating agency reduced Greece’s credit rating
from A to A-, falling again in 2009 to BBB+, slumping further in 2011 to CC
with it currently standing at B-. (Moody’s, 2015) with the graph below showing
that Greece has reported a fiscal deficit for the past 19 years! A government having
a fiscal deficit is the exact same as a company losing money, have you ever
heard of a company losing money for the past 19 years being given a A credit
rating? No, neither have I.. So why is a country that has reported losses for
many years and has had its credit rating significantly reduced still considered
as the basis of a risk free rate?!
Source: Trading Economics
Many financial markets assume that any company poses a
higher risk than the government, therefore anyone borrowing will pay the risk
free rate plus a premium, if the interest rate charged by the government goes
up so will the interest rate paid by any company or individual. Not only that, the entire financial system
seems to be based on one very volatile and shaky variable.. the government
rate!
Greece has been in recent news lately and can be seen as a
primary example of a country that should not be considered as the basis for a
risk free rate. They have a public debt
of 350 million euros and had to appeal for aid from the International Monetary
Fund (IMF) and the EU because it could no longer borrow on the markets (Yahoo
News, 2015). Greece received an EU bailout of 110 billion euros and then what
happens? They can’t pay it back.. (The
Guardian, 2015) The current Greek bailout package ends on the 28th
of February and if they don’t reach an agreement, they will run out of cash,
who would have thought an entire country could end up in a debt crisis so
disastrous that they literally don’t have a penny?
Thankfully on February 25th Greece and the
Eurozone finance ministers agreed on a reform plan, a four month extension of
their 172 million euro bailout (The Financial Times, 2015) (BBC News, 2015) However
the financial security of Greece still remains widely debated as the four month
extension of their bailout is a short term solution to a very long term
problem. Athens stock market surged by
10% as a result of the news and Greek borrowing costs fell as investors now
view Greece’s debt as less risky. (The Guardian, 2015)
Recent news articles about the Greek debt crisis evidence
just how volatile and risky a government can become due to an economic
recession, Greece along with several other countries will never be able to pay
off all its debt, so why would they still be considered as risk free? Countries
like Greece are prime examples of why governments should not be used as the
basis of a risk free rate, the economic recession has highlighted that maybe
governments aren't as risk free as previously perceived and may have rendered
the idea of a risk free rate obsolete. Should the idea of a risk free
rate be labelled useless it would have a significant affect on modern portfolio
theory and possibly the way investors view stock markets with the economist
arguing 'the sovereign debt crisis may eventually cause some re-thinking
in academia'. (The Economist, 2010)
References
BBC
News. (2015, February 24). BBC News - Greece debt crisis: Eurozone backs reform
plans. Retrieved from http://www.bbc.co.uk/news/world-europe-31606986
Markowitz, H.
(1952). Portfolio Selection. The journal of finance, 7(1),
77-91.
Moodys.
(2015). Greece, Government of Credit Rating - Moody's. Retrieved from
https://www.moodys.com/credit-ratings/Greece-Government-of-credit-rating-348330
The
Economist. (2010, May 10). Financial theory: The risk-free rate and corporate
finance | The Economist. Retrieved from http://www.economist.com/blogs/buttonwood/2010/05/financial_theory
The
Economist. (2014, March 11). Investing: The new risk-free rate? | The
Economist. Retrieved from
http://www.economist.com/blogs/buttonwood/2014/03/investing
The
Financial Times. (2015, February 25). Financial Times | Error | Akamai Error.
Retrieved from
http://www.ft.com/cms/s/0/72f18370-bd09-11e4-b523-00144feab7de.html#axzz3SrkIlT4r
The
Guardian. (2015, February 24). Eurozone approves Greek deal, but creditors
voice doubts - as it happened | Business | The Guardian. Retrieved from
http://www.theguardian.com/business/live/2015/feb/24/greek-bailout-reform-plan-eurogroup-live-updates
The
Guardian. (2015, February 9). Greece is playing to lose the debt crisis poker
game | Business | The Guardian. Retrieved from
http://www.theguardian.com/business/2015/feb/09/greece-is-playing-to-lose-the-debt-crisis-poker-game
Trading
Economics. (2015, February 26). Greece | Credit Rating. Retrieved from
http://www.tradingeconomics.com/greece/rating
Trading
Economics. (2015). Greece Government Budget | 1995-2015 | Data | Chart |
Calendar | Forecast. Retrieved from
http://www.tradingeconomics.com/greece/government-budget
Yahoo News. (2015, February 19). Greece debt crisis
timeline - Yahoo News UK. Retrieved from
https://uk.news.yahoo.com/greece-debt-crisis-timeline-155536389.html#owqsRWf
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