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The modern portfolio theory came to fruition in 1952, published by the Journal of Finance and authored by Harry Markowitz. It quickly became the most influential economic theory of modern investing.
The concept is based on Markowitz’s prediction that it is feasible for an investor to design an ideal portfolio to maximise net returns by taking aboard a quantifiable portion of risk.
Put simply, Markowitz believed that investors could reduce their risk through diversifying utilising a quantitative method in the process.
Modern portfolio theory states that it is not sufficient to just look at the expected risk and return of a particular stock.
Through investing in multiple different stocks, an investor can gain the rewards of diversification – primarily a decrease in the overall portfolio risk.
Modern portfolio theory quantifies the positives to diversification.
For a majority of investors, the risk that is at the forefront of their minds when buying a stock is that the returns will be less than predicted – this is known as deviation from the average return.
Modern portfolio recognises that each stock has its own ‘standard deviation’ from the mean, which is what investors label risk.
Markowitz illustrated through his theory that it is not just about selecting stocks that have large potential returns, but equally important is selecting the adequate combination of stocks to effectively diversify – or as he called it ‘spreading one’s eggs’.
Systematic Risk vs Unsystematic Risk
Markowitz’s’ theory highlights that there are two components to the risk associated with individual stock returns.
Systematic risk is the risk that cannot be avoided as it is embedded in the foundations of the financial sector.
Recessions, interest rates and trade wars are all example of systematic risks – investors can’t control these.
Unsystematic risk is the risk associated to specific stocks such as a change in operations or a decline in profits.
As you increase the contents of your portfolio you are able to diversify this risk away and mitigate any chance of a major effect on your portfolio through individual stock movements.
Modern Portfolio Theory and The Market
Markowitz’s theory has substantially impacted on how investors understand risk, returns and portfolio management throughout global markets.
Due to its immense popularity, the theory dictates how modern money managers act and conduct their work.
The strategy of passive investing is just one example of the many different strategies that incorporate the modern portfolio theory into their framework.
Modern portfolio theory is incorporated into passive investing by way of investors selecting index funds that are low cost and effectively diversified.
In passive investing, losses related to any single stock are not substantial enough to decrease performance due to the diversification that has occurred through the index funds.
The widespread success and prominence of passive investing is a clear display of the ubiquity of the modern portfolio theory in current financial markets.
Drawbacks
As widespread as the modern portfolio theory might be, it still has some drawbacks.
For instance, it commonly requires investors to reconsider notions of risk – leading its users to be stuck in a sort of paradox.
It demands that you take on a perceived risky investment in order for you to reduce your overall portfolio risk, a complete contradiction.
It does not quite make sense to some investors when they first become exposed to the theory.
It is because of this paradox that new investors unfamiliar with complex portfolio management techniques often avoid getting involved with the theory.
Moreover, modern portfolio theory assumes that an investor is likely to choose stocks that’s individual performance is separate of other investments in their portfolio.
Despite this, market historians have concluded that there are no such tools.
When the market is under stress, investments that were thought to be seemingly independent act as though they are correlated.
Conclusion
The overall message of the theory is that the market is hard to win against – and the people who are successful are those who take on an above average amount of risk.
It is also alluded to that the risk takers will meet their downfall when the markets drop.
Billionaire investor Warren Buffet provides sound advice when he encourages investors to remember it “is just a theory”.
Portfolio success relies on the skill of its manager – the investor.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
