Modern Portofolio Theory
Investors seldom, if ever, consider their entire portfolio as anything but a collection of individual investments, regardless of whether those investments are individual stocks, mutual funds, or any of numerous other assets, such as bank certificates of deposit, bonds, or coin collections. Few consider whether adding a new investment to a portfolio affects the overall risk parameters of the portfolio, or whether it helps to diversify their holdings. Usually asset allocation is totally ignored. This is not a good thing.
There exists a large body of knowledge that has collectively become known as modern portfolio theory. MPT tells us that investors can successfully (and easily) use a scientific approach to compile an investment portfolio. It’s worthwhile to make a brief study of this collection of knowledge because it contains ideas you can easily adopt to make your own investing more efficient and more profitable. One of the great benefits of MPT is that it shows how to increase the expected profits and lower overall risk at the same time MPT is concerned with the methods used to compile an investment portfolio and with the performance of that portfolio. Investors can easily earn the risk-free rate of return by purchasing U.S. Treasury bills.4 But to earn more, investors must accept the fact that a certain amount of risk must be accepted. It’s generally understood in the investment world that the greater the risk of an investment, the greater the potential reward. This must be true, or else no one would ever knowingly accept greater risk. It’s important to point out that the term “risk” is usually considered to represent the chances of losing money from an investment. According to MPT, risk is much more than that; it’s also a measure of how much the return on an investment varies from the expected return. Thus, risk is a measure of the uncertainly of the future.
The work of Harry M. Markowitz changed the way investment managers think, when he demonstrated that including certain classes of assets in a portfolio influenced not only the profit potential of that portfolio, but also its volatility, or the rate at which the value of a portfolio fluctuates.
The major conclusion of MPT that concerns our discussion is how to construct an investment portfolio that aims for higher profits with reduced risk. Markowitz did the original work in this field, and others have made significant contributions. Among those are Professors Sharpe, Cootner and Fama. A good discussion of MPT can be found in the text authored by Rudd and Clasing.8 The theory is not some obscure topic of interest only to academics, but is widely used in today’s investment universe. Markowitz and Sharpe shared the Nobel Prize in economics in 1990 for their contributions to this field.
The early development of MPT relied heavily on statistics, and the pioneering work is highly technical. Nevertheless, the basics of MPT can be explained in simple terms (the more complex math remains available for those readers interested in such details10). The discussion here is limited to explaining what MPT is, why it’s important for today’s investor to understand its basic teachings, and how you can easily build a portfolio based on its precepts.
Here is a simple summary of how MPT describes the thought process behind investing:
An investment is made in a security, or portfolio of securities, in anticipation of receiving a monetary reward. The expected reward is the average reward that results from holding the specific investment(s). Some years the return on the investment exceeds the expected return, and some years the return on the investment is less. The investment universe is filled with uncertainties, and, therefore, there is a certain degree of risk encountered when attempting to collect the reward. The risk is a measure of the uncertainty of earning the expected return.
Thus (states the theory), an investor chooses among investment possibilities based entirely on the two measures of risk and reward, attempting to minimize the former and maximize the latter.
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