Markowitz’s Modern Portfolio Theory - What Is It & How It Works

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Markowitz’s Modern Portfolio Theory - What Is It & How It Works

CENTRAL CONCEPTS OF MARKOWITZ'S MODERN PORTFOLIO THEORY

In 1952, Harry Markowitz presented an essay on Modern Portfolio Theory for which he also received a Noble Price in Economics. His findings greatly changed the asset management industry, and his theory is still considered as cutting edge in portfolio management.

There are two main concepts in Modern Portfolio Theory, which are;

  • Any investor's goal is to maximize Return for any level of Risk

  • Risk can be reduced by creating a diversified portfolio of unrelated assets

Other names for this approach are Passive Investment Approach because you build the right risk to return portfolio for broad asset with a substantial value and then you behave passive and wait as it growth.

 MAXIMIZE RETURN - MINIMIZE RISK

Let's briefly define Return and Risk. Return is considered to be the price appreciation of any asset, as in stock price, and also any Capital inflows, such as dividends. In general Standard Deviation is a fair measure of risk as we want a steady increase and not big swings which might possibly end up as loss.

Risk is evaluated as the range by which the asset’s price will on average vary, known as Standard Deviation. If an asset's price has 10% Deviation from the mean and an average expected Return of 8% you may observe Returns between -2% and 18%.

In a practical application of Markowitz Portfolio Theory let's assume there are two portfolios of assets both with an average return of 10%, Portfolio A has a risk or standard deviation of 8% and Portfolio B has a risk of 12%. As both portfolios have the same expected return, any investor will choose to invest in portfolio A as it has the same expected earnings as portfolio B but with less risk.

It is important to understand risk; it is a necessary concept, as there would be no expected reward without it. Investors are compensated for bearing risk and, in theory, the higher the Risk, the higher the Return.

Going back to our example above it may be tempting to presume that Portfolio B is more attractive than Portfolio A. As portfolio B has a higher risk at 12%, it may obtain a return of 22%, which is possible but it may also witness a return of -2%. All things being equal it is still preferable to hold the portfolio that has an expected range of returns between +2% and +18%, as it is more likely to help you reach your goals.

DIVERSIFIED PORTFOLIO & THE EFFICIENT FRONTIER

Risk, as we have seen above, is a welcomed factor when investing as it allows us to reap rewards for taking on the possibility of adverse outcomes. Modern Portfolio Theory, however, shows that a mixture of diverse assets will significantly reduce the overall risk of a portfolio. Risk, therefore, has to be seen as a cumulative factor for the portfolio as a whole and not as a simple addition of single risks.

Assets that are unrelated will also have unrelated risk; this concept is defined as correlation. If two assets are very similar, then their prices will move in a very similar pattern. Two ETFs from the same economic sector and same industry are likely to be affected by the same macroeconomic factors. That is to say, their prices will move in the same direction for any given event or factor. However, two ETFs from different sectors and industries are highly unlikely to be affected by the same factors.

This lack of correlation is what helps a diversified portfolio of assets have a lower total risk, measured by standard deviation than the simple sum of the risks of each asset. Without going into any detail, a bit of math might help to explain why.

Correlation is measured on a scale of -1 to +1, where +1 indicates a total positive correlation, prices will move in the same direction par for par, and -1 indicates the prices of these to stocks will move in opposite directions.

If correlation between all ETF pairs is 1, then it would seem reasonable that the total risk of the portfolio is equal to the sum of the weighted standard deviations of each individual ETF. Whereas a portfolio where the correlation of asset pairs is lower than 1 must lead to a total risk that is lower than the simple sum of the weighted standard deviations.

The magic of building different pairs is that by different combination it is possible to achieve basically every risk to return combination, even different from the risk to return level of the single components.

MARKOWITZ EFFICIENT FRONTIER

The concept of Efficient Frontier was also introduced by Markowitz and is easier to understand than it sounds. It is a graphical representation of all the possible mixtures of risky assets for an optimal level of Return given any level of Risk, as measured by standard deviation.

efficient frontier


The chart above shows a hyperbola showing all the outcomes for various portfolio combinations of risky assets, where Standard Deviation is plotted on the X-axis and Return is plotted on the Y-axis.

The Straight Line (Capital Allocation Line) represents a portfolio of all risky assets and the risk-free asset, which is usually a triple-A rated government bond.

Tangency Portfolio is the point where the portfolio of only risky assets meets the combination of risky and risk-free assets. This portfolio maximizes return for the given level of risk.

Portfolio along the lower part of the hyperbole will have lower return and eventually higher risk. Portfolios to the right will have higher returns but also higher risk.

Markowitz Portfolio Theory (Modern Portfolio Theory or Passive Investment Approach) is the base idea of the Ways2Wealth concept. Read more in the other articles to understand the Ways2Wealth Investment Approach.


Author: Gino D'Alessio 





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