Modern Portfolio Theory
In
1990, Harry Markowitz, William Sharpe, and Merton Miller, three noted
financial economists, won the Nobel Memorial Prize for Economics for
their work in developing Modern Portfolio Theory as a portfolio
management technique. Modern Portfolio Theory has been used to develop
and manage investment portfolios for large institutions, as well as
individual investors. There are four components to Modern Portfolio
Theory.
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1.
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Investors inherently
avoid risk.
Investors are often more concerned with risk than they are with reward.
Rational investors are not willing to accept risk unless the level of
return compensates them for it.
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2.
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Securities markets are
efficient.
The "Efficient Market Hypothesis" states that while the returns of
different securities may vary as new information becomes available,
these variations are inherently random and unpredictable. Assets are
re-priced every minute of the day according to what news comes out. As
new information enters the market, it is quickly absorbed into the
prices of securities, and thus hard to capitalize on. In fact,
advancing information technology and increased sophistication on the
part of investors are causing the markets to become even more efficient.
The
implications of the Efficient Market Hypothesis are far-reaching for
investors. It implies that one should be deeply skeptical of anyone who
claims to know how to "beat the market." One cannot expect to
consistently beat the market by picking individual securities or by
"timing the market".
The Efficient
Market Hypothesis is at odds with traditional investment strategies. It
has, however, been supported by numerous academic studies, both
theoretical and empirical. These studies show, among other things, that
the risk-adjusted returns achieved by professional investment managers
are no better than those of the market as a whole. This was primarily
due to the expenses and taxes incurred with active management. That's
the bad news. The good news is that the rate of return of the capital
markets is darn good (10%+ over time).
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3.
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Focus on the portfolio
as a whole and not on individual securities.
The risk and reward characteristics of all of the portfolio's holdings
should be analyzed as one, not separately. An efficient allocation of
capital to specific asset classes is far more important than selecting
the individual investments.
As
the pie chart shows, your asset allocation can determine over 90% of
the performance variation of your investment portfolio. How your
investment dollars are allocated far outweighs the potential effects of
individual security selection and market timing.
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4.
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Every risk level has a
corresponding optimal combination of asset classes that maximizes
returns.
This is called the "Efficient Frontier". Portfolio diversification is
not so much a function of how many individual stocks or bonds are
involved, but the relationship of one asset to another. We call this
relationship "correlation". The higher a correlation between two
investments, the more likely they are to move in the same direction.
The
efficient frontier represents the range of hypothetical portfolios that
offer the maximum return for any given level of risk. Portfolios
positioned above the range are unachievable on a consistent basis.
Portfolios below the efficient frontier are inefficient portfolios (too
much risk, not enough reward). The ideal portfolio exists somewhere
along the efficient frontier.
The
portfolio represented by point A is inefficient because portfolios
exist with the same value but less risk (Portfolio B) and portfolios
with the same risk but more value (Portfolio C) as well as portfolios
with a combination of these two conditions. The Efficient Frontier, as
originally defined in Modern Portfolio Theory, is a line that
represents the continuum of all efficient portfolios.
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