Asset Allocation and Its Role in Modern Portofolio Theory

What does MPT tell an investor about how to choose the components of a portfolio? The first idea is to diversify one’s holdings and to allocate part of the investment capital among several asset classes. Reasonably enough, this strategy is known as asset allocation. Not so many years ago, asset allocation meant owning a variety of stocks and bonds and some cash equivalents.

The prudent man rule reinforced this type of thinking among fiduciaries, or those responsible for investing other people’s money.Today MPT goes further and focuses on the portfolio as a whole, and not on its individual components. But proper diversification remains an essential ingredient of MPT.

When following MPT to build a portfolio, it’s not sufficient to compile a portfolio simply by investing in different asset classes (e.g., stocks, bonds, gold, and real estate). MPT teaches that it’s important to find the optimal allocation of assets satisfying both the investor’s risk tolerance and reward (expected rate of return). It’s important to own a variety of investments that perform differently in the marketplace. In other words, there should be minimal correlation in the performance of each individual investment with each of the other investments. If it sounds difficult to build a portfolio one stock at a time that satisfies these parameters, especially for an individual public investor, be assured that it is indeed difficult. But don’t fret, as there is an easy method to accomplish this goal for the portion of your investment capital that you allocate to the stock market. A well-qualified financial advisor ought to be able to help you achieve the type of portfolio recommended by MPT for any assets you own that are not stock market related.

Again, it’s important to reiterate that our discussion focuses on only that portion of your assets you have allocated to investing in the stock markets of the world. This book makes no recommendation on how you should otherwise allocate your assets. MPT tells us that asset allocation should not be ignored, as it represents the best method of reducing the overall risk of your portfolio. Numerous books offer advice on how to allocate assets in accordance with MPT, and we’ll leave that discussion to them.

The Prudent Investor
The prudent man rule contains guidelines for those responsible for investing other people’s money. The purpose of the rule is to offer protection to investors by providing those fiduciaries with investment guidelines. Over the years, the rule has changed with the times. At one point, it would have been considered lunacy to invest the savings of a public investor in the stock market. After World War II, as inflation became important in making financial decisions, it was considered extremely imprudent for a fiduciary not to invest in the market. Today it is not enough to merely invest in stocks, and the prudent man rule requires that fiduciaries invest at least part of an investor’s funds via passive investing, using index funds. Passive investing is consistent with the teachings of MPT and represents an important part of our overall recommended investment strategy.

At one time, a fiduciary had the difficult responsibility of being certain that each investment was appropriate for an investor. Today, taking MPT into consideration, the prudent investor rule has been revised to “focus on
the portfolio as a whole and the investment strategy on which it is based, rather than viewing a specific investment in isolation.” As a result, it’s acceptable for fiduciaries to recommend shares that would be risky as standalone investments, as long as the entire portfolio is appropriate for the investor.

Diversification
Diversification is an essential element when following MPT. The easiest way for public investors to diversify has been to own shares of traditional mutual funds. Their very existence is one reason why so many Americans are currently stock market investors, as mutual funds make it easy for public investors to own a professionally managed diversified portfolio of stocks. The wisdom of relying on these professional money managers is one of the subjects covered in MPT.

This review is from: Create Your Own Hedge Fund: Increase Profits and Reduce Risks with ETFs and Options (Wiley Trading)

This book covers the basics of this strategy very well; however it contains way too much filler information, and not enough substance. The author treats the reader as a novice to the market; but in reality no stock market novice would even begin to understand this strategy - therefore the author misses his target audience!

In my opinion, it is good entry entry-level reading for the market beginner who wants to understand the basics of a hedge fund; however it is not for the seasoned trader demanding greater insight in to a leading-edge strategy.

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Modern Portfolio Theory

People invest money in the stock market with one primary goal in mind: to earn a satisfactory return on that investment. Some consider investing to be a full-time occupation with the goal of earning enough to provide for their day-to-day living expenses on a continuing basis. Some will be retiring soon and must plan to begin using their investment nest egg to meet expenses. Others have a much longer time horizon and are planning 30 or 40 years into the future. With such a variety of time frames and purposes, there is no single investment strategy that suits all investors. There is no single “best” portfolio of investments to own.

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.


This review is from: Create Your Own Hedge Fund: Increase Profits and Reduce Risks with ETFs and Options
The author skillfully enables his readers to understand the rationale behind trading decisions with a multitude of examples that make the lessons come to life. 

The book also contains useful background information, references and statistics to support the author's ideas. I tried it, and so far, it really works. I make my own decisions now and am happy with the results. Don't be afraid - if I can do it, so can you. As Wolfinger says, I feel like I'm running my own small fund. 

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