Modern Portfolio Theory

Modern portfolio theory (MPT) takes a contrary position to traditional stock picking. The father of MPT, Professor Harry Markowitz of the City University of New York, created a system that looks at the performance of a portfolio as a whole rather than the approach of an analyst who looks at each individual security. Investments within the portfolio are then described statistically by their expected short and long term volatility. Volatility is another term for risk, and the goal of MPT is to find a portfolio with the maximum expected return for any level of risk.

The system Markowitz developed in the 1950s would wait many years until put to practical use. Due to the sheer volume of calculations based on historical data to determine the true volatility of a portfolio with many different investments there simply wasn't enough computing power available till the late 1970s.

The basis of Modern Portfolio Theory is really diversification. The concept of diversification is simple. By spreading investments between asset classes and different countries you are spreading the risk as well. You may also benefit from opportunities as they arise around the world. It should be obvious though, that if you spread your investments they will be less risky than investing in 1 single security. What may not be obvious is that for an identical amount of risk, diversification can also increase returns.

Volatility and risk go hand in hand and in most cases actually mean the same thing. Volatility increases your risk of loss of principal and this risk worsens as your time horizon shrinks. So it makes sense that investors have an interest in minimizing volatility within their portfolios. To accomplish this, investors cannot solely rely on low risk investments, as the results would most likely be a low rate of return. The solution is to combine high risk and low risk investments in such a way that the low and high-risk investments work together to minimize or eliminate some of the fluctuations. The resulting portfolio should produce a higher average return with lower overall volatility.

When it comes time to make assess the selection of securities within a portfolio you can start by combining different securities, based on their past performance (rates of return and standard deviation) on a risk return graph. The results are a region bounded by an upward-sloping curve, which is known as the efficient frontier.

It's clear that for any level of risk you would like to create a portfolio that provides the greatest potential for return. This means that you will always want a portfolio that lines up along the efficient frontier line. This is where the most efficient portfolios reside.

MPT makes the general assumption that investors are risk-averse. Based on this assumption, an investor will always choose the lowest risk investment for any given expected rate of return. For investors to assume a higher rate of return there must be present the potential to earn a higher rate of return.

A summary of Modern Portfolio can be described in the old adage "Don't put all your eggs in one basket." but it takes this one step further by verifying that you can reduce risk as well as improve the performance in your portfolio with the proper research.