Modern Portfolio Theory
Modern Portfolio Theory (MPT) was developed by the economist Harry Markowitz and the paper from which the theory came, Portfolio Selection*, won him the Nobel Prize in Economics in 1952. It outlines two fundamental ideas:
- All investors will seek the maximum level of returns possible for their level of risk tolerance
- A well-diversified portfolio can significantly mitigate risk.
The theory broke new ground in the way it postulated that individual investments should be considered within the wider context of an overarching investment portfolio and its overall level of risk and return.
Markowitz theorised that within the context of a carefully diversified portfolio, if some assets performed poorly, others would perform well in compensation. As such, your portfolio should be considered as a whole, rather than examining the volatility of its constituent parts.
In a nutshell, MPT theorised what we all know instinctively: don’t put all your eggs in one basket.
MPT in the 21st century
MPT and its relevance to portfolio diversification continues well into the 21st century. Whether an investor has an active or a passive approach, and whatever their risk tolerance, the overarching advice given today is that diversification by percentage in different instruments and sectors will serve them best – and that’s MPT at its most basic level.
MPT has led to the use of quantifying statistics such as the beta coefficient which is a measure of volatility (also known as systematic risk i.e. interest rate fluctuations, recessions, wars, etc.) which is used as a comparison to the unsystematic risk (risk relating to a particular company or industry sector) across the market as a whole. Beta expresses the returns of a particular security in relation to movements in the market. Beta is used in CAPM (capital asset pricing model) for pricing securities with a higher than average risk profile.
So, theory begets modelling and while MPT has been fundamental in providing a foundation for wealth management and investing strategies for decades, it is only one economic theory and has limitations in the practical sphere. In the end, successful investing depends on the individual approach and knowledge of the investor and/or their investment manager.
Blacktower Financial Management
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* https://www.math.ust.hk/~maykwok/courses/ma362/07F/markowitz_JF.pdf Accessed 17-09-19