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Modern Portfolio Theory

What is The Modern Portfolio Theory?


One of the most important and influential economic theories dealing with finance and investment, The Modern Portfolio Theory (MPT) was developed by Harry M. Markowitz and published under the title "Portfolio Selection" in the 1952 Journal of Finance.   Prior to Markowitz’s work, investors focused on assessing the risks and rewards of individual securities in constructing their portfolios. Standard investment advice was to identify those securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these. Following this advice, an investor might conclude that railroad stocks all offered good risk-reward characteristics and compile a portfolio entirely from these.  Detailing a mathematics of diversification, Markowitz proposed that investors instead focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that each individually have attractive risk-reward characteristics.  In a nutshell, investors should select portfolios not individual securities.

MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification* - chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification*, also known as not putting all of your eggs in one basket.  The gist of MPT is that the market is hard to beat and that the people who beat the market are those who take above-average risk.   It is also implied that these risk takers may take significant losses when markets turn down.

For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls "risk".   The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any single one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two stocks: one that pays off when it rains and another that pays off when it doesn’t rain.  A portfolio that contains both assets will always pay off, regardless of whether it rains or shines.  Adding one asset to another can reduce the overall risk of an all-weather portfolio.

In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one’s nest eggs.  Modern portfolio theory has had a marked impact on how investors perceive risk, return and portfolio management. The theory demonstrates that portfolio diversification* can reduce investment risk.  In fact, modern money managers routinely follow its precepts.

 

Sharpe Ratio Dynamics

Markowitz’s ideas were later picked up by William F. Sharpe to create the backbone of the capital asset pricing model (CAPM), which is used extensively today by both investors and company managers to determine the required level of return on an asset.  The success of the CAPM and its associated "Beta" coefficient helped to standardize the process of evaluating assets and their risk premium.   The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been.


The 1990 Nobel Prize:  Markowitz, Sharpe and Miller


These three winners may have shared the 1990 Nobel for Economics "for their pioneering work in the theory of financial economics", but each made extraordinarily useful individual contributions to investors. Harry Markowitz is the godfather of modern portfolio theory, having given us the same theories of mean-variance portfolio analysis that most money managers still use today. His mathematical approach to creating an optimal portfolio opened the door to modern diversification* techniques and educated us on the critical tradeoffs between risk and return.

Markowitz’s ideas were later picked up by William Sharpe to create the backbone of the capital asset pricing model (CAPM), which is used extensively today by both investors and company managers to determine the required level of return on an asset. The success of the CAPM and its associated "Beta" coefficient helped to standardize the process of evaluating assets and their risk premium.

Merton Miller doesn’t have the honor of having a financial term named after him (a la the "Sharpe ratio" and "Markowitz efficient frontier"), but he brought long-overdue attention to corporate finance and individual investors. His theories have helped guide the way managers run companies on behalf of shareholders; specifically, he was able to prove that because investors can diversify portfolios on their own, companies should simply try to maximize shareholder value and not worry about finding the perfect ratio of debt capital to equity capital.


* A Word on Diversification

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.  Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others.

Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.   In addition, diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.    Diversification and asset allocation do not assure a profit or protect against losses in a declining market.