When we talk to friends and family about investing, we often hear, “Don’t put all your eggs in one basket” and “Work with someone who cares if you can sleep at night during a downturn.” Commercials for investment firms often tout more sophisticated versions of the same ideas, like “portfolios tailored to each individual’s unique investing objectives” or “Diversification protects you against market volatility.”
These familiar refrains are derived from Modern Portfolio Theory (MPT), devised by Harry Markowitz in 1952. His article “Portfolio Selection” was published in the Journal of Finance and outlined the model for which Markowitz later won the Nobel Prize in 1990. For nearly seven decades, MPT has provided financial advisors and money managers with a reliable way to select portfolios for their clients.
Modern Portfolio Theory Explained
The hypothesis seems like common sense now that every investor has been exposed to its tenets through friendly wisdom and financial services marketing: Naturally risk-averse investors can create an “efficient frontier” of investment portfolios to maximize return for a given level of market risk.
An “efficient frontier” is an archaic term, but it is important to understand. It refers to the set of optimal portfolios that offer the greatest expected return for an investor’s risk level. Its premise, as investor psychology proves over and over, is that investors are willing to take on more risk for the possibility of higher returns.
Given a certain risk tolerance, investors can create portfolios that mitigate their concerns. Conversely, given a desired rate of return, an investor can create a portfolio with the lowest possible risk. Each individual investment within a portfolio is a tool to move the needle one way or the other — to optimize potential returns or to minimize risks. The risk levels of each investment are determined using two measures: variance and correlation. These measures help us calculate the standard deviation or the percentage assigned to the risk-reward efficiency of a portfolio. These terms are explained in great detail in MBA Finance programs like that offered by Southeastern Oklahoma State University.
If you have an investment account, one of the visual tools you have probably noticed is the quadrant graph showing where an investment stands in terms of growth vs. value. Dr. Han-Sheng Chen, assistant professor of finance at Southeastern Oklahoma State University, explains some of the differences.
“Growth stocks are expected to grow quickly in terms of sales, earnings, cash flows and dividends. They usually have a high P/E ratio and a low Book-to-Market equity ratio,” he explains. “Consequently, they appear more ‘expensive’ than their peers. Contrarily, ‘value’ stocks are usually selling on the ‘cheap’, mainly due to the uncertainty of the firm’s future prospects. So, if you talk about risk/reward under this context, growth stocks are the ones with lower risk, and value stocks are the ones with higher risk. Literature also shows evidence that value stocks, on average over a long-term period, earn higher rate of returns than growth stocks. Some call this a ‘value premium’ puzzle.”
One of the pioneering conclusions that Markowitz came to in his paper is that diversification of assets correlates to a more “efficient frontier” over time. As individual investments within an asset class (like biotechnology companies or consumer staples) tend to move up and down in value together, an investor reduces risk by holding investments across asset classes. Through diversification, the entire portfolio is more immune to dramatic swings that occur within asset classes more often than they do in the broad market.
For instance, precious metals may nosedive by 30 percent in a year while pharmaceuticals soar by 32 percent. The investor sees their account totals rising slowly, but surely, and sleeps quite soundly due to their diversification. Over time, their exposure to multiple asset classes ensures that they will reap the benefits of rising tides across industries, when they occur.
Brilliant, But Not Perfect
While some of the most brilliant people who have ever lived have been economists and money managers, none have ever created a foolproof investing theory that can protect investors against sudden and significant losses. The limitation of Modern Portfolio Theory is that it is designed to protect against “undiversifiable” risk — having too many investments concentrated in one asset class. What it cannot do is predict a global economic crisis or a bear market.
Though MPT cannot predict short-term market moves, its emphasis on diversification cushions the risks of sudden downturns. In part, it does so by weighting portfolios for risk-averse investors (including those nearing retirement) more heavily in low-risk/low-reward investments including bonds. Conversely, MPT can provide long-term investors with exposure to dramatic short-term gains, using a higher concentration of stocks.
The validity of Modern Portfolio Theory continues to be proven by the experiences of investors as well as peer-reviewed journals and academic studies. It is not often that we call an idea born in 1952 “Modern,” but this theory may survive for centuries before it becomes antiquated.
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