While there is no secret formula or strategy that can guarantee investment success, following a strategy that offers high returns and relatively low risk is what every modern investor strives to achieve. . It is interesting to note that this strategy did not actually exist until the second half of the 20th century.
Renowned economist Harry Markowitz came up with the idea for a thesis on “Portfolio Selection” in 1952, which consisted of theories that transformed the landscape of portfolio management, which would later be known as of “modern portfolio theory”.
Modern portfolio theory (MPT) won him the Nobel Prize in economics almost four decades later.
Even now, its Modern Portfolio Theory (MPT) continues to be a popular investment strategy and portfolio management tool that, if used correctly, can result in diverse and profitable returns on investment.
Decades before becoming a Nobel Laureate, Harry Markowitz built an illustrious career as an economist.
Born August 24, 1927 in Chicago, Illinois, Markowitz was interested in physics, astronomy, and philosophy in his early days and was a strong believer in the ideas of David Hume.
He continued to follow 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 Commission for Research in Economics.
After earning his bachelor’s degree, Markowitz continued his studies at the University of Chicago with a major in economics. While there, Markowitz took lessons from some of the most notable academics of the time, including Milton Friedman, Jacob Marschak, and Leonard “Jimmie” Savage.
In 1952, Markowitz joined the RAND Corporation, and in the same year his article on “Portfolio Selection” was published in the Journal of Finance.
What is MPT theory
In MPT theory, instead of focusing on the risk of each individual asset, Markowitz demonstrated that a diversified portfolio is 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 could actually be quite low.
Over 60 years after its introduction, the fundamentals of MPT still hold true. Let’s take a look at this popular portfolio management strategy and understand what makes the principles of this theory so effective.
The origins of MPT
Prior to Markowitz’s development of MPT, most investment processes focused only on individual stocks.
Investors used to browse through available assets and find assets that could produce 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 their future cash flows. Stocks capable of generating more money at a faster rate were given great preference.
Markowitz says the net present value theory was flawed, because selecting the âbestâ portfolio with that logic involved selecting a single stock with the highest expected NPV.
He said this approach is inherently risky, and while experts believe that a good portfolio is diverse, there is no method available for investors to achieve that diversity.
While developing his theory, Markowitz looked at probability and statistics to further strengthen his knowledge. He says that if a stock’s price was believed to change randomly, statistical tools, including mean and variance, could be used to form more diverse portfolios. In the case of two or more stocks, an investor might consider a correlation.
The concept of MPT
Markowitz created a formula that allowed investors to mathematically negotiate risk tolerance and reward expectations, resulting in an ideal portfolio.
This theory was based on two main concepts:
- The objective of each investor is to maximize the return regardless of the level of risk.
- Risk can be reduced by diversifying a portfolio with unrelated individual securities
During the development of MPT, Markowitz assumed that investors were risk averse, preferring a portfolio with less risk for a given level of return.
In this case, investors should only accept high-risk investments if they believe they can obtain a greater reward.
Two components of risk
According to MPT, there are two components of risk to the returns of individual stocks.
Systematic risk: these are market risks that cannot be reduced by diversification, as the entire market will show losses that will negatively affect investments. It is important to note that MPT does not claim to be able to moderate this type of risk, as it is inherent in an entire market.
Unsystematic risk: Also known as specific risk, unsystematic risk is specific to individual stocks, which means that it can be diversified as investors increase the number of stocks in their portfolio.
In a truly diversified portfolio, the risk of each asset itself contributes very little to the overall risk of the portfolio. Therefore, investors can reduce the risk associated with individual assets by combining a diversified portfolio of assets.
The efficient border
Markowitz said it is important for investors to determine what level of diversification is best for them.
This, he said, could be determined by what has been called the âefficient frontier,â a graphical representation of all possible combinations of risky securities for an optimal level of return given a particular level of risk.
Using the efficient frontier, investors could
- At each level of return, create a portfolio that offers the lowest possible risk.
- For each level of risk, create a portfolio that offers the highest return.
According to Markowitz, any portfolio that leaves the efficient frontier is considered sub-optimal because it carries too much risk relative to its return, or too little return relative to its risk.
He says that a portfolio that falls below the efficient frontier does not provide sufficient return relative to the level of risk. Portfolios to the right of the efficient frontier present a higher level of risk for the defined rate of return.
Markowitz believes that a portfolio at the top of the curve is effective because it gives the maximum expected return for the given level of risk.
According to Markowitz, the process of selecting a portfolio is an important activity and investors should carefully choose the stocks or assets in the portfolio.
He says stocks should be selected based on the impact of each asset on the others as the overall value of the portfolio changes.
Diversify and rebalance
Markowitz believes that the biggest mistake amateur investors make is that they buy when the market goes up, assuming it will go up further, and sell when the market goes down, assuming the market will go down further. .
He says professional investors won’t make this mistake and try to rebalance their portfolios.
âDiversify and rebalance. Don’t watch TV. The professional investor will outperform the market just because they rebalance. If your advisor says, given your personality and so on, you should have a 60:40 mix of stocks and bonds, and then the market goes up, you don’t have a 60:40 mix, you have a 70:30 mix, and you have to sell.
âAnd if the market goes down, you’ve got a 50:50 mix, and you’ve got to buy. There are these poor people who buy above and sell below; and the institutional investor is on the other side. And whatever the small investor loses, the big investor wins, âhe says.
Markowitz believes that a smart investor simply buys and holds a well-diversified portfolio, using index funds.
Markowitz says equity portfolios should be diversified with different types of stocks such as large cap, small cap, value, growth, foreign and domestic stocks.
âYour portfolio must also be efficient. It is not important to be exactly on the efficient frontier. ” he said.
Markowitz saved regularly and invested half of his money in stocks and the other half in bonds to grow while controlling risk. When he thought he had accumulated too much money in one or the other category, he stopped putting money into it for a while and directed his savings to the other group.
âI visualized my grief if the stock market skyrocketed and I wasn’t – or if it went down and I was completely in it. So I split my 50/50 contributions between stocks and bonds, âhe said.
When investors are faced with market volatility, they often panic and lose confidence. But, using MPT’s investment model, investors can rebalance their portfolios to reflect market conditions that could be effective even in times of turbulence.
(Disclaimer: This article is based on Harry Markowitz’s article published by The Journal of Finance)