Modern Portfolio Theory
Modern concepts of portfolio management are heavily influenced by work published by economist Harry Markowitz in 1952 in the Journal of Finance. His work was the beginning of what is now known as Modern Portfolio Theory. How important was Markowitz’s theory? His work was largely responsible for the modern financial practice of diversification. When you hear finance advisers saying you need to have a diversified portfolio, their recommendation is based largely on the work of Markowitz and contemporaries. In fact, his theory was so influential that he received a Nobel Prize in economics in 1990 because of his research and its long-lasting effect on how capitalists approach investing today.
Modern Portfolio Theory Assumptions
Markowitz starts out with a number of basic assertions.
1. All investors would like to avoid risk whenever possible. He defines risk as a standard deviation of expected returns.
2. Rather than look at risk on an individual security level, Markowitz argues that you measure the risk of an entire portfolio. When considering a security for your portfolio, don’t base your decision on the amount of risk that carries with it. Instead, consider how that security contributes to the overall risk of your portfolio.
3. For each individuals risk tolerance there is a point at which risk and return are balanced. This is each individuals point on the maximum efficiency curve.
4. Risk and return go hand in hand. Generally speaking, if you want more return, you need to hold riskier assets in your portfolio.
A key concept in modern portfolio theory is correlation. Markowitz considers how all the investments in a portfolio can be expected to move together in price under the same circumstances. Correlation measures how much you can expect different securities or asset classes to change in price relative to each other.
For instance, high oil prices might be good for oil companies, but bad for airlines and trucking firms who need to buy the fuel. As a result, you might expect that the stocks of companies in these two industries would often move in opposite directions. These two industries have a negative (or low) correlation. You’ll get better diversification in your portfolio if you own one oil and one trucking company, rather than two oil companies.
Diversification Minimizes Risk and Maximizes Return
According to Markowitz when you put all this together, your portfolio that has much higher average return than the level of risk it contains. So the process of building a diversified portfolio and spreading out your investments by asset class is really just a means of managing risk and return.