Discussing Modern Portfolio Theory

April 25, 20238 min read
Discussing Modern Portfolio Theory
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Key Takeaways

  • Modern Portfolio Theory (MPT) is a framework that enables investors to optimize their portfolios based on their risk tolerance and expected return.
  • In any discussion regarding Modern Portfolio Theory (MPT), the foundational concepts of risk, return, and diversification need to be thoroughly explored.
  • One of the key benefits of MPT is that it offers a quantifiable measure of portfolio risk.

Modern Portfolio Theory (MPT) is a critical financial concept that has revolutionized investment strategies since its inception. Originally introduced by Harry Markowitz in the 1950s, it has become a cornerstone of investment risk management, advocating for diversified portfolios as a means to optimize returns. The concept received a Nobel prize, underscoring its significant impact on financial theory and practice.

MPT is a framework that enables investors to optimize their portfolios based on their risk tolerance and expected return. It postulates that the risk and return of a portfolio are not merely an aggregate of the individual securities, but also depend on the correlation among those securities. This theory empowers investors to make informed decisions and has profound implications for asset allocation.

Core Components of Modern Portfolio Theory

In any discussion regarding Modern Portfolio Theory (MPT), the foundational concepts of risk, return, and diversification need to be thoroughly explored. These components underpin the theory’s core tenets, guiding how portfolios should be constructed and managed for optimal performance.

Risk and Return

Risk and return form a symbiotic relationship within MPT. Risk, often quantified by the standard deviation of returns, denotes the potential for financial loss. It is the level of uncertainty about the returns an investment may yield. High standard deviation implies that the return on an investment may significantly vary, indicating higher volatility and, therefore, higher risk.

Return, conversely, is the profit or loss made on an investment over a certain period. In essence, it’s the reward for taking on investment risk. Typically measured as a percentage, the return on investment is the degree to which the investment’s value has grown or diminished over time.

In MPT, the pivotal relationship between risk and return is that they are directly proportional. The potential for higher returns usually comes with increased risk. Conversely, lower risk investments generally yield lower returns. This risk-return tradeoff is at the heart of MPT’s asset allocation guidance. The challenge for any investor is to find the optimal balance between risk and return that aligns with their specific financial goals and risk tolerance.

Diversification and Correlation

Another core component of MPT is diversification, underpinned by the correlation among different assets. Correlation, in this context, measures the degree to which the returns of two assets move in relation to each other.

If two assets are perfectly correlated (correlation coefficient +1), their prices move in perfect sync. This means if one asset’s price increases, the other’s price also increases, and vice versa. On the other hand, if two assets have a perfect negative correlation (correlation coefficient -1), their prices move in opposite directions. When the price of one asset increases, the price of the other decreases, and so forth.

In a diversified portfolio, the aim is to include a mix of assets that are not perfectly correlated. The rationale behind this is that when some assets are down, others might be up. This lack of perfect correlation can reduce the portfolio’s overall risk. In other words, the negative performance of some investments may be offset by the positive performance of others, leading to more stable overall portfolio returns.

Correlation and diversification are inherently linked in MPT. Diversification isn’t simply about increasing the number of different assets in a portfolio but strategically choosing a mix of assets based on their correlation. The aim is to reduce overall portfolio risk without significantly diminishing expected returns. Diversification, therefore, serves as a practical risk management tool, offering investors the opportunity to mitigate potential losses and optimize returns.

Benefits of Modern Portfolio Theory

One of the key benefits of MPT is that it offers a quantifiable measure of portfolio risk. By considering the interaction between different assets, rather than assessing each in isolation, it provides a holistic view of portfolio risk.

MPT also guides investors in asset allocation. It encourages investment in a mix of asset classes, including public equities, fixed income products, real estate, and other alternative investments, based on the investor’s risk aversion and return expectations.

Moreover, MPT introduced the concept of an efficient frontier. This frontier represents the set of portfolios that offer the highest expected return for a given level of risk or, conversely, the lowest risk for a given level of return.

Real-World Application of Modern Portfolio Theory

Imagine an investor named Sophia, an enthusiast of the vibrant art scene. Sophia is considering investing in a boutique art gallery located in a trendy neighborhood known for its artistic charm. She is captivated by the gallery’s potential for steady rental income and the prospect of the property’s appreciation due to the neighborhood’s rising popularity. Yet, she recognizes the risks involved: the local property market might fluctuate, the demand for art can be fickle, and selling such a unique piece of real estate might prove challenging if she ever needed to liquidate her investment.

Here’s where the application of Modern Portfolio Theory becomes particularly useful. To manage these risks and enhance potential returns, Sophia doesn’t limit her investment horizon to the art gallery alone. Instead, she looks to build a diversified portfolio, adding different types of assets.

She considers investing in publicly traded stocks of technology firms whose innovative solutions are disrupting their respective industries. Sophia also looks into fixed income products like corporate bonds issued by established, blue-chip companies, which could provide steady income with lower risk.

On top of that, she explores other alternative investments. Sophia looks into mutual funds focusing on green technologies, seeing an opportunity in the global trend towards sustainability.

By doing so, Sophia applies the principles of Modern Portfolio Theory. She builds a portfolio that includes the art gallery (real estate), public equities (technology stocks), fixed income products (corporate bonds), and other alternative investments (green technology mutual funds). The lack of perfect correlation between these assets allows Sophia to reduce her overall risk exposure. If the art gallery’s value dips due to a slump in the local art scene, this loss might be offset by gains in her technology stocks or the steady income from her corporate bonds.

In this way, MPT’s principles guide Sophia in constructing a diversified portfolio that aligns with her risk tolerance and return expectations, potentially improving her portfolio’s overall risk-return trade-off. Through this real-world example, the practicality and usefulness of Modern Portfolio Theory become clear.

Limitations and Criticisms of Modern Portfolio Theory

Despite its profound influence, MPT is not without its critics. Some argue that MPT relies heavily on historical data, which may not predict future market behavior. It also assumes that investors are rational and that markets are efficient, assumptions often challenged by behavioral finance studies.

MPT’s risk measure, standard deviation, considers both upward and downward price movements as risky, which may not align with an investor’s perspective who welcomes upward volatility.

Modern Portfolio Theory vs. Post-Modern Portfolio Theory

Both Modern Portfolio Theory (MPT) and Post-Modern Portfolio Theory (PMPT) play essential roles in shaping investment strategies, yet their approach towards risk, return, and portfolio construction notably differs.

Approach to Risk

MPT considers risk as the standard deviation of portfolio returns. In essence, it views both upside (positive) and downside (negative) price changes as risky since they contribute to volatility. This perspective can be at odds with many investors’ instincts, who typically welcome positive price changes and view only downside volatility as a true risk.

PMPT, however, aligns more with this intuitive investor perspective. It dismisses the idea that all volatility is risk. Instead, it defines risk as downside volatility or downside deviation. This means only negative returns, which lead to losses, are deemed risky. This approach can be more meaningful to investors as it focuses on the risk of losses, which is their primary concern.

Incorporation of Skewness and Kurtosis

While MPT bases its risk-assessment on an assumption of normally distributed returns, in reality, investment returns often display skewness and kurtosis, deviating from this assumption.

Skewness measures the asymmetry of a distribution. A negatively skewed distribution has a long left tail, indicating a higher probability of negative returns, while a positively skewed distribution indicates a higher chance of positive returns.

Kurtosis, on the other hand, measures the “tailedness” of a distribution. High kurtosis signifies a higher probability of extreme positive or negative returns (fat tails), while low kurtosis indicates a lower probability of extreme returns (thin tails).

PMPT introduces these two concepts to provide a more nuanced picture of risk. It acknowledges that returns are not always symmetrically distributed and that outliers (or extreme events) can significantly impact a portfolio. By accounting for skewness and kurtosis, PMPT provides a potentially more complete understanding of the risk landscape, allowing for a more thorough risk assessment.

Modern Portfolio Theory and Diversification

MPT’s central message is the power of diversification. By investing in a combination of different asset classes, including traditional and alternative investments, one can construct a portfolio that maximizes expected return for a given level of risk. This is particularly relevant for investors seeking to build retirement income or short-term liquidity.

MPT serves as a reminder that diversification isn’t just about investing in different securities or sectors but about finding assets whose returns are not perfectly correlated. This potentially improves the risk-return trade-off and moves the portfolio closer to the efficient frontier.

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Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Modern Portfolio Theory provides a valuable framework for understanding portfolio risk and return, guiding asset allocation, and leveraging the power of diversification. Despite its limitations and the emergence of alternative theories like PMPT, it remains a fundamental concept in investment management, offering insights to both novice and seasoned investors.