The Modern Portfolio Theory
If you were to craft the perfect investment, you would probably want its attributes to include high returns coupled with low risk. Not surprisingly, people spend a lot of time developing methods and strategies that come close to the "perfect investment". But none is as popular, or as compelling, as the Modern Portfolio Theory (MPT). Here we look at the basic ideas behind MPT and how MPT affects the management of your portfolio.
One of the most important and influential economic theories dealing with finance and investment, MPT was developed by Harry Markowitz and published under the title "Portfolio Selection" in the 1952 Journal of Finance. Thirty-eight years later, in 1990, he won the Nobel prize for what has become the frame upon which institutions and savvy investors construct their portfolios.
Modern Portfolio Theory allows investors to estimate both the expected risks and returns, as measured statistically, for their investment portfolios. In his article “Portfolio Selection” (in the Journal of Finance, in March 1952), Markowitz described how to combine assets into efficiently diversified portfolios. He demonstrated that investors failed to account correctly for the high correlation among security returns. It was his position that a portfolio’s risk could be reduced and the expected rate of return increased, when assets with dissimilar price movements were combined. Holding securities that tend to move in concert with each other does not lower your risk. Diversification, he concluded “reduces risk only when assets are combined whose prices move inversely, or at different times, in relation to each other.”
Dr. Markowitz was among the first to quantify risk and demonstrate quantitatively why and how portfolio diversification can work to reduce risk, and increase returns for investors.
Proper diversification amongst uncorrelated asset classes reduces volatility more efficiently than most people understand: The volatility of a properly diversified portfolio is less than the average of the volatilities of its component parts.
While the technical underpinnings of MPT are complex, and drawn from financial economics, probability and statistical theory, its conclusion is simple and easy to understand: a diversified portfolio, of uncorrelated asset classes, can provide the highest returns with the least amount of volatility.
Many investors are under the delusion that their portfolios are diversified if they are in individual stocks, mutual funds, bonds, and international stocks. While these are all different investments, they are all still in the same asset class and generally move in concert with each other. When the bubble burst in the stock market, this was made painfully clear! Proper diversification according to MPT is in different asset classes that move independently from one another.
One of the most uncorrelated and independent investments versus stocks are Professionally Managed Futures.
The value of professionally managed futures was thoroughly researched by Dr. John Lintner, of Harvard University, in a 1983 landmark study, “The Potential Role of Managed Futures Accounts in Portfolios of Stocks and Bonds.”
Lintner wrote that “the combined portfolios of stocks (or stocks and bonds) in leveraged managed futures accounts show substantially less risk at every possible level of expected return than portfolios of stocks (or stocks and bonds) alone.” Lintner specifically showed how managed futures can decrease portfolio risk, while simultaneously enhancing overall portfolio performance.
Managed Futures investments can carry a significant risk of loss. Managed Futures trading is not appropriate for all investors. Futures trading is not appropriate for all investors. Past performance is not indicative of future results.
For more on managed futures click here.
The Efficient Frontier
Now that we understand the benefits of diversification, the question of how to identify the best level of diversification arises. Enter the Efficient Frontier.
For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line is the efficient frontier.
Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.Click for larger view