A zero-investment portfolio is a collection of investments that has a net value of zero when the portfolio is assembled, and therefore requires an investor to take no equity stake in the portfolio. For instance, an investor may short sell $1,000 worth of stocks in one set of companies and use the proceeds to purchase $1,000 in stock in another set of companies.
Key Takeaways
- The zero-investment portfolio is a financial portfolio composed of securities that cumulatively result in a net value of zero.
- A zero-investment portfolio that requires no equity whatsoever is purely theoretical; a truly zero-cost investment strategy is not achievable for several reasons.
- The most important contribution of portfolio theory to our understanding of investments is that a group of stocks can earn investors a better risk-adjusted return than individual investments can; however, diversification of assets cannot eliminate risk completely.
Decoding the Zero-Investment Portfolio
A zero-investment portfolio that requires no equity whatsoever is purely theoretical and does not exist in the real world. Conceptually, this type of portfolio intrigues academics studying finance. Achieving a truly zero-cost investment strategy is implausible for several reasons. Firstly, when an investor borrows stock from a broker to sell it and profit from its decline, they must utilize much of the proceeds as collateral for the loan. Secondly, in the U.S., short selling is regulated by the Securities and Exchange Commission (SEC), making it challenging for investors to maintain an optimal balance of short and long investments. Lastly, buying and selling securities involve paying commissions to brokers, which adds costs to the investor, thereby involving one’s own capital.
The unique nature of a zero-investment portfolio means it does not have a portfolio weight. A portfolio weight is usually calculated by dividing the dollar amount that a portfolio is long by the total value of all the investments in the portfolio. Since the net value of a zero-investment portfolio is zero, the denominator in the equation is zero, rendering the equation unsolvable.
Insights from Portfolio Theory
Portfolio theory is vital for students and practitioners of finance and investing. The primary contribution of portfolio theory is demonstrating that a group of stocks can earn investors a better risk-adjusted return than could be obtained from individual investments. However, in most real-world markets, diversification of assets cannot wholly eliminate risk. An investment portfolio that guarantees a return without any risk is known as an arbitrage opportunity, but academic financial theory generally assumes such scenarios are not feasible in the real world. A true zero-investment portfolio would be considered an arbitrage opportunity if the rate of return it earns matches or exceeds the riskless rate of return (often assumed to be the rate one can earn from U.S. government bonds).
Arbitrage is the process of buying specific securities in one market while simultaneously selling the same or similar securities in another market. The principle of arbitrage can also be applied to buying and selling securities of comparable value in the same market. The goal of an arbitrage strategy is to minimize the overall risk of financial loss while capitalizing on opportunities to profit.
Related Terms: portfolio weight, arbitrage, diversification, riskless rate of return, short selling.
