Although there is no secret formula or strategy that can guarantee investment success, following a strategy that offers high returns and relatively low risks is what every modern day investor strives to achieve. It is interesting to note that this strategy did not actually exist until the latter half of the 20th century.
The famous economist Harry Markowitz came up with the idea of a thesis on ‘Portfolio Selection’ in 1952 which consisted of theories that changed the landscape of portfolio management which later became known as ‘Modern Portfolio Theory’.
Modern Portfolio Theory (MPT) earned him the Nobel Prize in Economics nearly four decades later.
To date, Modern Portfolio Theory (MPT) remains a popular investment strategy and portfolio management tool which if used correctly can lead to diversified and profitable investment returns.
Decades before being awarded the Nobel Prize, Harry Markowitz built a illustrious career as an economist.
Born on August 24, 1927 in Chicago, Illinois, Markowitz was interested in physics, astronomy, and philosophy in his early days, and was a follower of David Hume’s ideas.
He continued to pursue his interest in Hume’s ideologies throughout his undergraduate years at the University of Chicago. While studying at the university, Markowitz was also invited to join the Cowles Committee for Research in Economics.
After receiving his bachelor’s degree, Markowitz continued his studies at the University of Chicago with a major in economics. During his time there, Markowitz took classes under some of the notable academics of the time, including Milton Friedman, Jacob Marshak, and Leonard “Jimmy” Savage.
In 1952 Markowitz joined the RAND Corporation, and in the same year, his article on “Portfolio Choice” was published in the Journal of Finance.
What is the MPT theory?
In MPT theory, instead of focusing on the risk of each individual asset, Markowitz showed that a diversified portfolio was less volatile than the sum total of its individual parts.
Markowitz concluded that while each asset itself can be quite volatile, the volatility of the entire portfolio can actually be very low.
More than 60 years after its introduction, the basics of MPT still hold true. Let’s take a look at a popular portfolio management strategy, and understand what makes the principles of this theory so effective.
Prior to the development of MPT by Markowitz, most investing operations focused only on individual stocks.
Investors had the practice of looking at the available assets and finding the ones that were likely to generate decent returns without the investor taking too much risk.
Investors used the concept of net present value (NPV) to distinguish these high-quality stocks, while stocks were valued by discounting future cash flows. Stocks that were able to generate more money at a faster rate were preferred.
Markowitz says the net present value theory has some shortcomings in that choosing the “best” portfolio under this logic means choosing one stock with the highest expected net net worth.
This approach is inherently risky, he said, and while experts believed that a good portfolio was diversified, there was no way for investors to achieve such diversification.
While developing his theory, Markowitz considered probability and statistics to advance his vision. He says that if one believes that the stock price has changed randomly, then statistical tools including mean and variance can be used to form more diversified portfolios. In the event that there are two or more stocks, the investor can consider a correlation.
MPT . concept
Markowitz devised a formula that allows investors to mathematically trade off risk tolerance and reward expectations, resulting in an ideal portfolio.
This theory was based on two main concepts:
- The goal of every investor is to maximize the return for any level of risk
- Risk can be reduced by diversifying the portfolio through unrelated individual securities
While developing the MPT, Markowitz assumed that investors were risk averse, preferring a portfolio with lower risk for a given level of return.
Under the assumption, investors were expected to take high-risk investments only if they felt that they could obtain a greater reward.
Two components of risk
According to MPT, there are two components to individual stock returns risk.
Systematic Risk: Refers to market risk that cannot be reduced through diversification as the entire market will exhibit losses that adversely affect investments. It is important to note that MPT does not claim to be able to mitigate this type of risk, as it is inherent to the entire market.
Unsystematic risk: Also called specific risk, unsystematic risk is specific to individual stocks which means it can be diversified as investors increase the number of stocks in their portfolios.
In a truly diversified portfolio, the risk of each asset per se contributes little to the risk of the overall portfolio. Therefore, investors can reduce the risk of individual assets by combining a diversified portfolio of assets.
Markowitz said it is important for investors to determine the level of diversification that suits them.
He said this can be determined by the so-called “effective limit”, which is a graphical representation of all possible combinations of risky securities to obtain an optimal level of return given a given level of risk.
By using effective boundaries, investors can-
- At each level of return, create a portfolio that offers the least amount of risk possible.
- For each level of risk, create a portfolio that offers the highest return.
According to Markowitz, any portfolio that falls outside the bounds of efficiency is considered suboptimal because it has too much risk in relation to its return, or too little return in relation to its risk.
He says that a portfolio that is below the effective limits does not provide enough return when compared to the level of risk. Portfolios to the right of the effective boundary have a higher level of risk relative to the specified rate of return.
Markowitz sees the portfolio at the top of the curve as efficient, as it provides the maximum expected return for a given level of risk.
Choose a wallet
According to Markowitz, the portfolio selection process is an important activity and investors should choose the stocks or assets in the portfolio carefully.
He says stocks should be chosen based on how each asset affects the others as the overall portfolio value changes.
Diversification and rebalancing
Markowitz argues that the biggest mistake amateur investors make is that they buy when the market goes up, assuming it will go higher, and sell when the market goes down, assuming the market is going to go lower.
He says that professional investors will not make this mistake and will try to rebalance their portfolios.
“Diversification and rebalancing. Don’t look at TV. A professional investor will outperform the market just because it’s rebalancing. If your advisor says, looking at your personality and so forth, you should have a 60:40 mix of stocks and bonds, and then the market goes up, not You have a 60:40 mix; you have a 70:30 mix, and you have to sell.
“And if the market goes down, you have a 50:50 mix, and you have to buy. There are these poor individuals who are buying at prices and selling below; and the institutional investor is on the other side. Everything the small investor loses is gaining in big profits.”
Markowitz is of the opinion that the smart investor only buys and holds a well diversified portfolio, using index funds.
Markowitz says stock portfolios should be diversified with different types of stocks such as large, small, value, growth, foreign and domestic stocks.
“Your portfolio also has to be efficient. It’s not really important to be at the exact effective level. But if you’re not somewhere near it, the first time you have a crisis, like in 2000 or 2008, you have a problem,” he He said.
Markowitz saved regularly and put half his money in stocks and the other half in bonds to grow while controlling risk. When he thought he had collected too much in either category, he stopped putting money there for a while and directed the savings to the other group.
“I imagined my grief if the stock market went too high and I wasn’t in it — or if it plummeted too much and I was completely in it. So I split my contributions 50/50 between stocks and bonds.
When investors face volatility in the market, they often panic and lose confidence. But by using MPT’s investment model, investors can rebalance their portfolio to reflect market conditions that can be effective even in turbulent times.
(Disclaimer: This article is based on a research paper by Harry Markowitz published by the Journal of Finance)