Simplifying modern portfolio theory
You must have heard financial geeks discussing portfolio management and how it can be diversified. If you feel clueless, do not worry, you won’t feel the same after reading this article.
In 1952, legendary Harry Markowitz developed the modern portfolio theory (MPT) for which, he received Nobel Prize.
Introduction to MPT
MPT is a theory that seeks to maximise the expected returns for a given level of risk. It optimises the risk and returns trade-off through diversification in the portfolio. A portfolio is a basket of assets for which, diversification plays an important role. Investing in any single asset class may pose greater risks in the long term. A good mix of various assets such as bonds, equities, commodities, ETFs, etc can significantly reduce the portfolio risk and might reward investors with higher returns. As long as the assets are not perfectly correlated with each other, the total risk (variance) of the portfolio will reduce and the maximum expected returns can be achieved with acceptable risk. A positive correlation between two assets means both assets have a direct relationship with each other; if one goes up, the other will follow. On the other hand, a negative correlation has an inverse relationship between the assets. For example, bonds & equities usually have a negative correlation.
MPT assumes investors to be risk-averse, which means that they prefer taking a lesser risk for the given level of returns. They expect higher marginal returns for a slight increase in the marginal risk. MPT also assumes that markets are efficient, meaning to say that everyone has equal access to the information. It assumes variance of asset price as a proxy for risk.
How does it work?
The expected return is calculated as a weighted sum of the individual asset’s returns. For example, if there are three equally-weighted assets in the portfolio with expected returns of 6 per cent, 9 per cent and 12 per cent, then the expected return will be calculated as:
(6 per cent* 33 per cent) + (9 per cent* 33 per cent) + (12 per cent*33 per cent) = 9 per cent.
The total variance of the portfolio is calculated through a complex formula. Markowitz created a series of combinations of various risky assets and put them on a graph, with variance on the x-axis and expected returns on the y-axis. He called it an efficient frontier. Suppose, we have two different risky assets in the portfolio and we construct two different portfolios with the same expected returns of 10 per cent. Portfolio A has a standard deviation (square root of variance) of 5 per cent and portfolio B has 7 per cent. The investor will choose less risky portfolio A over B since portfolio A is more efficient.
Portfolio construction is a relatively recent invention in the finance world. It is under continuous research and modification. However, the path laid down by Nobel laureate Harry Markowitz is simply incredible and revolutionary!