Although there is no secret formula or strategy that can guarantee investment success, following a strategy that offers high returns and relatively low risk is what every modern-day investor strives to achieve. It is interesting to note that this strategy actually didn’t exist until the latter half of the 20th century.
Noted economist Harry Markowitz came up with the idea of a dissertation on “Portfolio Selection” in 1952 that consisted of theories that transformed the landscape of portfolio management which came to be later known as the “Modern Portfolio Theory.”
The Modern Portfolio Theory (MPT) earned him the Nobel Prize in Economics nearly four decades later.
Even now his Modern Portfolio Theory (MPT) continues to be a popular investment strategy, and a portfolio management tool which if used correctly can result in a diverse, profitable investment returns.
Decades before he became a Nobel laureate, Harry Markowitz built an illustrious career as an economist.
Born on August 24th, 1927, in Chicago, Illinois, Markowitz was interested in physics, astronomy, and philosophy in his early days, and was an avid follower of the ideas of David Hume.
He continued to follow his interest in Hume’s ideologies throughout his undergraduate years at the University of Chicago. While studying at the university, Markowitz was also invited to join the Cowles Commission for Research in Economics.
After receiving his Bachelor’s degree, Markowitz continued his studies at the University of Chicago with a specialization in Economics. During his time there, Markowitz took classes under some of the most notable academicians of that time, including Milton Friedman, Jacob Marschak, and Leonard “Jimmie” Savage.
In 1952, Markowitz joined the RAND Corporation, and in the same year, his article on “Portfolio Selection” was published in the Journal of Finance.
What is MPT theory
In the MPT theory, instead of focusing on the risk of each individual asset, Markowitz demonstrated that a diversified portfolio was less volatile than the total sum of its individual parts.
Markowitz concluded that while each asset itself could be quite volatile, the volatility of the entire portfolio could actually be quite low.
More than 60 years after its introduction, the fundamentals of MPT still remain true. Let’s look at this popular portfolio management strategy, and understand what makes the principles of this theory so effective.
The origins of MPT
Before the development of MPT by Markowitz, most investing processes focused only on individual stocks.
Investors had the practice of going through available assets and finding assets that were likely to produce decent returns without the investor taking too much risk.
Investors used the concept of net present value (NPV) to distinguish these high quality stocks, while stocks were valued by discounting their future cash flows. Stocks that were capable of generating more money at a quicker rate were given great preference.
Markowitz says the net present value theory had shortcomings as selecting the “best” portfolio under this logic meant selecting a single stock with the highest expected NPV.
He said this approach was risky by nature, and while experts believed a good portfolio was a diversified one, there was no method available for investors to achieve this diversity.
While developing his theory Markowitz looked at probability and statistics to further strengthen his insights. He says if one believed a stock’s price changed randomly, statistical tools including mean and variance could be used to form more diverse portfolios. In the instance of two or more stocks, an investor could consider correlation.
The concept of MPT
Markowitz created a formula that allowed investors to mathematically trade off risk tolerance and reward expectations, resulting in an ideal portfolio.
This theory was based on two main concepts:
- Every investor’s goal is to maximize return for any level of risk
- Risk can be reduced by diversifying a portfolio through individual, unrelated securities
During the development of MPT, Markowitz made the assumption that investors were risk-averse, preferring a portfolio with less risk for a given level of return.
Under the assumption, investors were expected to only take on high-risk investments if they felt they could get a larger reward.
Two components of risk
According to MPT, there are two components of risk for individual stock returns.
Systematic risk: This refers to market risks that cannot be reduced through diversification as the entire market will show losses that negatively affect investments. It’s vital to note that MPT does not claim to be able to moderate this type of risk, as it is inherent to an entire market.
Unsystematic risk: Also called specific risk, unsystematic risk is specific to individual stocks which means it can be diversified as investors increase the number of stocks in their portfolio.
In a truly diversified portfolio the risk of each asset itself contributes very little to overall portfolio risk. Therefore, investors can reduce individual asset risk by combining a diversified portfolio of assets.
The efficient frontier
Markowitz said it was important for investors to determine the level of diversification that best suited them.
This he said could be determined through what was called the ‘efficient frontier’, a graphical representation of all possible combinations of risky securities for an optimal level of return given a particular level of risk.
By using the efficient frontier, investors could-
- At every level of return, create a portfolio that offers the lowest possible risk.
- For every level of risk, create a portfolio that offers the highest return.
According to Markowitz, any portfolio that falls outside the efficient frontier is considered sub optimal because it carries too much risk relative to its return, or too little return relative to its risk.
He says a portfolio that lies below the efficient frontier doesn’t provide enough return when compared to the level of risk. Portfolios found to the right of the efficient frontier have a higher level of risk for the defined rate of return.
Markowitz is of the view that a portfolio found on the upper portion of the curve is efficient, as it gives the maximum expected return for the given level of risk.
According to Markowitz, the process of selecting a portfolio is an important activity and investors must carefully choose the shares or assets in the portfolio.
He says the shares must be selected on the basis of how each asset will impact others as the overall value of the portfolio changes.
Diversify and rebalance
Markowitz is of the view that the biggest mistake amateur investors make is they buy when the market goes up, on the assumption that it’s going to go up further, and they sell when the market goes down, on the assumption that the market is going to go down further.
He says professional investors will not make this mistake and try to rebalance their portfolio.
“Diversify and rebalance. Don’t look at television. The professional investor will outperform the market simply because they rebalance. If your adviser says, given your personality and so on, you should have a 60:40 mix of stocks and bonds, and then the market goes up, you don’t have a 60:40 mix; you have a 70:30 mix, and you’ve got to sell.
“And if the market goes down, you’ve got a 50:50 mix, and you’ve got to buy. There are these poor individuals who are buying at the top and selling at the bottom; and the institutional investor is on the other side. And everything the small investor loses the big investor gains,” he says.
Markowitz is of the view that a smart investor just buys and holds a well-diversified portfolio, using index funds.
Markowitz says that equity portfolios should be diversified with different types of stocks like large-cap, small-cap, value, growth, foreign and domestic stocks.
“Your portfolio should also be efficient. It’s not important to be exactly on the Efficient Frontier. But if you’re not somewhere near it then, the first time there’s a crisis, like in 2000 or 2008, you’ve got a problem,” he said.
Markowitz saved regularly and put half his money into stocks and half into bonds to grow while controlling risks. When he thought he had accumulated too much in either category, he stopped putting money there for a while and directed savings to the other group.
“I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds,” he said.
When investors are faced with market volatility, they often panic and lose confidence. But, by using the investing model of MPT investors can rebalance their portfolio to reflect market conditions that could be effective even in turbulent times.
(Disclaimer: This article is based on Harry Markowitz’s paper published by The Journal of Finance)