The theory that won a Nobel Prize
Are you an investor who avoids risks at all costs but wants to get the most returns you can, depending on the market list level? A paper called “Portfolio Selection” written by Harry Markowitz in 1952 where the “Modern Portfolio Theory” is explained. This paper can be found in the Journal of Finance, and if you are one of those people that I have mentioned, you should check out what this modern portfolio theory is and what it does. It might be the greatest thing you can learn today because it helped Harry Markowitz become a Nobel Prize winner.
What is Modern Portfolio theory?
The modern portfolio theory states that it is not enough for an investor to just look at an investment’s risk and return characteristics alone. Instead, he should also evaluate the investment’s impact on the portfolio as a whole. What does Markowitz mean when he said this? He says that an investor can always construct a portfolio with various assets that can make the most out of the returns for a given risk level. However, he is also saying that if there is an expected return in mind, the investor can also make a portfolio with the slightest possible risk.
There are different measures that we can use to produce statistics, such as correlation and variance. These measures tell us that a single investment’s performance is not that important compared to its impact on the portfolio as a whole. As mentioned earlier, if you are a conservative investor and are not comfortable with enormous risks for a specific level of return, you are perfect for MPT. An investor who wants to avoid risks should make multiple investments from different asset classes.
Why use the Modern Portfolio Theory?
MPT helps traders create better and diversified portfolios. In fact, the growth of exchange-traded funds can attest to that. Hence, MPT makes it easier for investors to access various asset classes. For instance, stock investors use MPT to avoid risks by dedicating a part of their portfolio to government bond ETFs. There will be fewer risks because we know that government bonds and stocks have a negative correlation. In this case, the variance of the asset classes helps in reducing the risks.
In another perspective, MPT can also help alleviate the volatility of a US treasury portfolio if the investor will dedicate at least 10% of it to a small capital value index fund or an ETF. Small-cap value stocks carry more risk than treasuries. However, they perform really well during high inflation, unlike bonds. Hence, the portfolio’s volatility will be less than if it only has government bonds in it. What’s better is the fact that the possible returns can be more.
Many efficient portfolios have ETFs from more than a single asset class.
Doubts on the Modern Portfolio Theory
Some skeptical people about MPT say that it only evaluates portfolios depending on the variance instead of the downside risks. For instance, there are two portfolios with the same variance and returns. MPT looks at them as equally attractive. One of them may have the variance due to the constant small losses, while the other may have variance because of seldom declines. Many would instead choose the frequent small losses because it looks more tolerable. On the other hand, another theory called “Post-modern portfolio” aims to improve MPT by lessening downside risks rather than variance.