The Secrets of Modern Portfolio Theory: A Comprehensive Guide
Harry Markowitz has passed away at the age of 95. He was the creator of the well-known economic theory that explains how to diversify an investor’s portfolio and a Nobel Prize recipient.
How does one determine the potential of building a portfolio of stocks?
Trying to predict which stocks will produce consistently high cashflows (dividends) in the future is one technique to do this. To determine whether purchasing the stock now makes sense, you would next compute what all of the future income would be worth in today’s value. There is some math required. Enter: Harry Markowitz.
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He was looking for a topic for his Ph.D. while studying economics at the University of Chicago. And he became interested in the financial markets after having a chance conversation with a broker. So he grabbed some books and began looking through them for inspiration.
He believed that if investors were exclusively concerned with stock returns, they would simply purchase the stock with the greatest potential. Any ‘reasonable’ investor would already act in that manner.
But he soon discovered it wasn’t how most people behaved. Investors did diversify their portfolios by purchasing numerous stocks. They were all adherents of the proverb “Don’t put all your eggs in one basket.” They were making an effort to lower their risk. Risk-taking was discouraged. Then what got the ball rolling for Harry Markowitz?
Where It All Began
Markowitz began by examining the patterns of past stock price behavior in connection to one another. Did they act similarly? Or did they act in complete contrast?
Then he made an effort to chart the link between risk and profit. The creation of an “efficient portfolio” was his aim. One that would enable investors to maximize their earnings while taking on the least amount of risk possible. To be clear, when Markowitz mentioned risk, he was referring to stock price fluctuations. is what is referred to as volatility.
This was the first time risk and reward in a portfolio had truly been calculated. The hypothesis, according to those reviewing it, was “not economics, not mathematics, not business administration, and not literature.” They believed that Markowitz seemed to be more interested in the algorithms that would aid in portfolio construction. He wasn’t paying attention to the underlying economic theory. However, it was still a really good dissertation. Likewise, Markowitz received a Ph.D.
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This research is mostly limited to academic communities. The hypothesis became well-known in 1959 when he published it as a book. Suddenly, wealth managers started using MPT, or Modern Portfolio Theory, to build client portfolios that maximize return and reduce risk.
And forty years later, in 1990, Markowitz was awarded the Economics Nobel Prize. Therefore, there is just one question left: what does the whole theory revolve around?
The Modern Portfolio Theory (MPT)
An asset portfolio that maximizes expected return for a specific degree of risk can be put together by investors using the Modern Portfolio Theory (MPT), a theory of investments. According to the hypothesis, investors always favor the portfolio with lower risk for a given amount of projected return.
Therefore, by Modern Portfolio Theory, a higher level of risk must be offset by a higher expected return for an investor. The fundamental principle of diversification, according to MPT, is that keeping a portfolio of assets from various classes is less risky than doing the same for a portfolio of similar assets.
Investors who use modern portfolio theory can reduce market risk while maximizing return. Beginning with the following underlying presumptions:
Your portfolio’s assets cannot be viewed separately. Instead, you should consider how they connect in terms of possible returns and the amount of risk that each asset entails. When you consider a portfolio as an organic whole, you might choose several assets with uncorrelated performance to balance the risk presented by each option. Future investment return forecasting is quite challenging. Instead, to get a rough idea of how different investments might perform in the future, investors should look backward at long-term historical returns.
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Investors model a variety of different portfolios with varied levels of risk and expected returns while keeping these principles in mind.
Conclusion
A few people have criticized MPT. Although it may theoretically make sense, some people claim that the fluctuations in the relationship between stocks are constantly changing. And even a minor alteration in this relationship could need a total makeover of the companies in the portfolio.
Practically speaking, that is bad news for long-term investors. Others contend that the risk calculation is inaccurate and needs to be corrected. Nevertheless, MPT is still used today despite everything. Even now, you may still find websites that promote the use of Modern Portfolio Theory in their models.
Goldman Sachs also defended the renowned 60:40 portfolio that resulted from MPT earlier this year.
