Modern Portfolio Theory Introduction

By definition, investment is the sacrifice of certain present value for possible, yet uncertain, higher future value. It does not matter whether the investment is in stocks, bonds, real estate, precious metals or other assets. The bottom line is your desire for increased wealth.

So how is value determined? There is a tremendous amount of academic information on how value should be determined. However the only real determinant of value, present or future, is simply the forces of supply and demand. Asset values increase because there are more buyers than sellers and values decrease because there are more sellers than buyers.

For the most part, traditional stock pickers use various methods to determine fair value and, in turn, use the information to determine whether to buy or sell. You can be sure that these valuation methods are quite logical. As well, there are a significant number of studies to prove the validity that some of these methodologies are more reliable than others. However, the underlying presumption is that other investors will eventually react logically to reach the same conclusion. If you've followed the stock market for any length of time, you know that investors don't always react logically and rationally. This approach rarely considers decisions based upon risk.

An alternative approach to managing investments involves decisions based upon modern portfolio theory. Modern portfolio theory was developed as a result of studies involving investor behavior and the seemingly obvious investor concern with risk and return. These studies began in March of 1952, when a landmark article written by a young man was published in the Financial Analysts Journal entitled Portfolio Selection. Often cited as the father of modern portfolio theory, Harry Markowitz used statistics to study investor behavior, determined how to measure and consider risk, as well as, how to use that data to create portfolios that optimize investor behavior. His work was so valid and inspiring that, in 1990, he was awarded a Nobel Prize in Economics for this work. The true significance of his work was the development of a framework to create portfolios with greater expected returns per risk taken than could be otherwise obtained from individual investments.

Risk

By definition, risk is the danger or possibility of loss and is often explained in terms of unsystematic risk and systematic risk in the investment world. Unsystematic risk is the risk of price change due to the unique circumstances and can be virtually eliminated through diversification. On the other hand, systematic risk - also called market risk - is common to an entire class of assets or liabilities as a result of investor behavior. Harry's work determined that asset allocation could protect against systematic risk because different portions of the market tend to underperform at different times.

The systematic risk of an investment or portfolio is measured by the standard deviation of its rate of return. The standard deviation is a statistic that tells you how near, or far away, all the various return numbers are from the average when observing a set of data. With investments, systematic risk refers to volatility. Volatility is found by calculating the standard deviation of changes in return rates. If returns of a stock move up and down rapidly over short time periods, it has high volatility. If returns are fairly consistent, it has low volatility. The greater the volatility, the greater your risk of loss.

Efficient Portfolios

So, then, I should only look for investment opportunities with low volatility characteristics, right?

No, not exactly. There are really few types of investments that have low volatility, and those investments generally provide low return opportunities. Also, because there are so few low volatility investments, you would likely be putting all of your eggs in one basket. This would not be a good thing.

In his studies of investor behavior, Markowitz recognized that different types of investments experienced positive or negative investment performance - characteristics of return and volatility - at different times. From this he also determined that when combining two investments that perform differently together, the portfolio exhibited less volatility than expected. Taking this observation significantly further, Harry devised an ingenious computational model to identify all possible portfolios offering investors both maximum expected return for varying levels of risk and minimum risk for varying levels of expected return. When depicted graphically, this set of efficient portfolios form a locus line referred to as the efficient frontier - this is where the best portfolios are. 

efficient-frontier.jpg

(From this graph, the shaded area represents all possible portfolios and the line along the shaded area is the efficient frontier.)

How is it that this was conceived in the 1950's and you are only beginning to hear about it today?

Although Markowitz' model was ingenious, it required significant computation capabilities to use - a level thought almost impossible in its day. However, with the evolution of personal computers and office productivity software, this capability is now within reach. In fact, the study of modern portfolio theory is gaining greater attention at colleges and universities each semester and professional money managers are paying heed as their traditional ways of doing business are being challenged.

Wait, we're not yet done!

Leveraging off of the work done by Harry Markowitz, another brilliant economist, William Sharpe, devised a way to find the optimal portfolio from Harry's Efficient Frontier. This computational model is referred to as the Capital Asset Pricing Model. Since Markowitz had provided a model for the maximizing of investor behavior, it is not surprising that Sharpe was not alone in exploring its implications for market equilibrium. It should also not be surprising that, in 1990, William Sharpe too shared the podium with Harry to receive his own Nobel Prize in Economics for this work. 

efficient-frontier-capital-asset.jpg

(The graph above is a simple illustration of how the two combine.)

(This white paper was originally written by Henry V. Kaelber, CPA, CFP® Copyright ©2003) 

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