15.4 Overview of modern portfolio theory

Modern portfolio theory

The Modern Portfolio Theory is the optimal tool in developing methods and strategies that come close to achieving 'perfect investment'. It was developed by Harry Markowitz and what it states is that it is not enough to look at the expected risks and returns of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification and thereby reduce the risk factor of a portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket. For an investor the risk is the deviation from average return. Therefore each stock has its own standard deviation from the mean, which MPT calls 'risk'. Markowitz starts out with the assumption that all investors would like to avoid risk whenever possible. He defines risk as a standard deviation of expected returns.

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any single one of the individual stocks (provided the risks of the various stocks are not directly related). Markowitz then considers how all the investments in a portfolio can be expected to move together in price under the same circumstances. This is called 'correlation' and it measures how much you can expect different securities or asset classes to change in price relative to each other. For instance, high fuel prices might be good for oil companies, but bad for airlines that need to buy the fuel. As a result, you might expect that the stocks of companies in these two industries would often move in opposite directions. These two industries have a negative (or low) correlation. You will get better diversification in your portfolio if you own one airline and one oil company, rather than two oil companies. When you put all this together, it's entirely possible to build a portfolio that has a much higher average return than the level of risk it contains. So when you build a diversified portfolio and spread out your investments by asset class, you are really just managing risk and return. In other words, investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one’s precious money. According to the Modern Portfolio Theory, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return. This theory states that the risk for individual stock returns has two components – systematic risk and unsystematic risk (also known as specific risk).  Unsystematic risk is specific to individual stocks and can be diversified as you increase the number of stocks in your portfolio (explained in session 15.1). It represents the component of a stock's return that is not correlated with general market moves. For a well-diversified portfolio, the risk - or average deviation from the mean - of each stock contributes little to portfolio risk. Instead, it is the difference or co-variance between the individual stocks' levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks.

EFFICIENT FRONTIER

However, how do you identify the best level of diversification? The answer lies in getting into the 'efficient frontier'. It represents that set of portfolios that has the maximum rate of return for every given level of risk, or the minimum risk for every level of return. 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.

Figure 2 shows the efficient frontier for just two stocks – a high risk/high return technology stock (Infosys) and a low risk/low return consumer products stock (ITC Ltd).

This can be worked for different asset classes. The optimal portfolio is the portfolio on the efficient frontier that has the highest utility for a given investor. An efficient portfolio lies on the upper part of the curve as it gives the maximum expected return for a given level of risk. As a rational investor you will hold your portfolio in such a way as to align with the effective frontier. The maximum level of risk that the investor will take determines the position of the portfolio on the line.

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