During market volatility, an investment portfolio constructed by optimising expected returns based on the level of market risk would be effective
Modern portfolio theory (MPT), was proposed by professor Harry Markowitz in 1952 for which he was awarded the Nobel Prize in 1990 in economics. Does this theory still holds true and will it improvise your investment returns? Let us discuss this in detail.
Markowitz, who is the father of modern portfolio theory, explained various aspects investments and its impact on the individual investor. His theory explains how to construct an investment portfolio by optimising expected returns based on the level of market risk.
Accordingly, by combining various asset classes into one portfolio, overall portfolio risk can be minimised and higher return can be achieved than that with a portfolio that is not properly optimised. This theory help the investors to construct portfolios to maximise returns while limiting risk as much as possible.
Investors are risk-averse
To start with, Markowitz assumed that majority of the investors are risk-averse. This means that they are more comfortable with less risk, and nervous and anxious with increased risk. Accordingly, given a choice between a higher return possibility with greater risk, and a lower return possibility with less risk, most people tend to prefer the portfolio with the least risk, even if it means a lower return. So, given two portfolios, an investor will naturally prefer one that indicates the highest return possibility with the lowest risk.
Types of risk
Modern portfolio theory states that the risk for individual stock returns has two elements; namely, systematic and unsystematic risk. Systematic risk is the market risk that cannot be diversified away. For instance, interest rates, recessions and wars are the risks that one cannot do away with. Unsystematic risk or specific risk, are those risks which are specific to individual shares, such as a change in management or a decline in operations, etc. This kind of risk can be diversified when you increase the number of shares in your portfolio.
According to Markowitz, the process of selecting a portfolio is an important activity. One must carefully chose the shares or assets in the portfolio. The shares must be selected on the basis of how each asset will impact others as the overall value of the portfolio changes. For a well-diversified portfolio, the risk is measured though standard deviation of each shares contributes little to portfolio risk. Instead, it is the difference or covariance between individual share’s levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks. He also suggests a limit known as the efficient frontier.
How to use MPT?
Once when you have a diversified portfolio with assets divided up by percentage in different instruments and sectors such as 60% equities, and within equities —40% large-cap, 20% small-cap, 20% in commodities and 20% in fixed income instruments. This is the use of modern portfolio theory.
To conclude, when investors are faced with market upheaval, they often panic and lose confidence. This investing model of using modern portfolio theory helps you to rebalance your portfolio to reflect market conditions and could be effective even in turbulent times.
The writer is a professor of finance & accounting, IIM Tiruchirappalli