Modern Portfolio Theory: Brief Overview
By Mike Darkowski from Scrab.com, a tool making everything you read about in this article easy (and reducing time needed for stock fundamental analysis to seconds).
Investing can be a daunting task, especially for those who are new to the world of finance. With so many investment strategies and options available, it can be overwhelming to determine the best approach for your financial goals.
One popular investment strategy that has gained traction in recent years is Modern Portfolio Theory (MPT). In this article, we will provide a brief overview of MPT and how it can be used as a systematic investment strategy, allowing for lowering the level of portfolio risk.
Modern Portfolio Theory (MPT)
Modern Portfolio Theory, also known as portfolio theory or mean-variance analysis, is an investment strategy that was developed by economist Harry Markowitz in the 1950s.
The theory is based on the idea that investors can minimize total portfolio risk and maximize expected returns by creating a diversified portfolio of assets. This is achieved by selecting a combination of assets that have a low correlation with each other, meaning they do not move in the same direction at the same time.
The main principle of MPT is that investors should not put all their eggs in one basket. Instead, they should spread their investments across different asset classes, such as stocks, bonds, and commodities. By diversifying their investment portfolios, investors can reduce their overall risk because if one asset performs poorly, the others may perform well and balance out the losses.
MPT also takes into account the risk-averse investors. This is the level of risk an investor is willing to take on in order to achieve their desired returns. By understanding their hazard tolerance, investors can create a less risky portfolio that aligns with their financial goals and comfort level.
Optimal Portfolio: Matter of Asset Allocation
One of the key benefits of modern portfolio theory is that it can be used as a systematic investment strategy. This means that investors can create a plan for regularly investing a set amount of money into their portfolio over a period of time.
This approach helps to reduce the impact of market fluctuations and allows investors to take advantage of dollar-cost averaging, where they can buy more shares when prices are low and fewer shares when prices are high.
It is this ability to balance market risk that is crucial to efficient portfolio management. Here’s the good news, too – there are many ways to achieve this goal: from equal weighting or subjective preferences to far more advanced methods such as Hierarchical Risk Parity (HRP).
What are the pros and cons of each? Check out what you can choose from!
- Traditional Asset Allocation
That is, for example, equal weighting or subjective preferences. These methods are, however, a bit unreliable – in the case of the first of them, each asset in the portfolio is assigned the same values, without differentiating even on the basis of potential individual risk or return, which consequently easily leads to erroneous investment decisions. Advantages? Definitely simple implementation.
- Mathematical Framework: Data-Driven Approaches to Asset Allocation
- Another option aimed at reducing risk at the same time optimizing returns is the already mentioned Modern Investment Theory, hierarchical risk parity (HRP) and the Black-Letterman model.
MPT is mostly based on the assumption of portfolio diversification – and in-depth analysis of historical data and mathematical models.
HRP, on the other hand, is a slightly more modern and advanced approach (developed in 2016 by Marcos Lopez de Prado). Its basis involves using hierarchical clustering and risk parity algorithm to allocate individual assets, which leads in a straight line to a more balanced portfolio.
A third option, namely Black-Litterman model, is closely related to the concept of market equilibrium. This model takes into account data from the market – and at the same time also investors’ forecasts, based not on past results, but rather looking ahead with predictions.
Does Diversification Eliminate Risk?
As you can probably guess, complete elimination of risk is not possible. This does not mean, however, that there’s no way to reduce the downside risk – which is possible to achieve thanks to diversification of assets.
It is worth emphasizing at this point that in the life of every investor, there are two different risks: systematic risk and idiosyncratic risk. The former relates to the risk common to the entire market, while the latter relates to the risk of a specific asset. Diversification has no power to systematic risk – unfortunately, you need to remember that all assets carry this risk.
A balanced approach to risk is at the heart of MPT – as the theory is based on 3 key principles:
1. Risk and return trade-offs
There is a certain level of risk that must be accepted by investors, as long as they wish to achieve higher expected returns.
2. Diversification
Asset allocation according to the MPT assumptions must be done in different asset classes (and different markets) – only in this way will you be able to reduce overall portfolio risk and increase expected return level.
3. The efficient frontier
An efficient frontier is an idea representing the ideal market portfolio combination and the highest possible return for a given level of risk; according to its basis, investors should plot all possible combinations of high-risk assets in the space of expected return.
But what does this look like in practice? Investors using the efficient frontier methodology emphasize that the key to success is to put all visible combinations of asset weights on a scale – and decide on that basis whether it is more important to them to minimize volatility or maximize risk-adjusted expected return.
In the process of working on the efficient frontier, we can distinguish 3 successive stages:
- crossing of all possible connections of chosen assets on a scale of return (y-axis) against risk (x-axis);
- taking a closer look at the potential combinations of these investments;
- finding the optimal portfolio variance.
Interesting fact: in the dictionary of investors there is the term “risk free asset” – it refers to investments with a guaranteed future value level, while ensuring no potential loss. One example of this type of asset with a guaranteed expected return is the so-called debt issued by the U.S. government (bonds, notes and treasuries).
The Bottom Line
Choosing the right method of creating an entire portfolio is difficult – much depends on the investor’s risk tolerance, dreamed future investment returns and staying up to date with market risks knowledge.
Modern Portfolio Theory is a popular investment strategy that has been used by most investors for decades. By diversifying their portfolio and understanding specific risks combined, rational investors can make proper portfolio selection, minimize risk and maximize returns.
MPT can also be used as a systematic investment strategy, making it a popular choice for investors looking for a long-term approach to investing. It is a strategy worth considering for those looking to grow their wealth through smart investments, achieving high expected value from returns and eliminating risky assets through the investment portfolio balancing journey.
At Scrab we are keeping our fingers crossed for your decisions – we wish you success in creating a well-diversified portfolio and, of course, successful work to reduce risk as much as possible!
Jesse Pitts has been with the Global Banking & Finance Review since 2016, serving in various capacities, including Graphic Designer, Content Publisher, and Editorial Assistant. As the sole graphic designer for the company, Jesse plays a crucial role in shaping the visual identity of Global Banking & Finance Review. Additionally, Jesse manages the publishing of content across multiple platforms, including Global Banking & Finance Review, Asset Digest, Biz Dispatch, Blockchain Tribune, Business Express, Brands Journal, Companies Digest, Economy Standard, Entrepreneur Tribune, Finance Digest, Fintech Herald, Global Islamic Finance Magazine, International Releases, Online World News, Luxury Adviser, Palmbay Herald, Startup Observer, Technology Dispatch, Trading Herald, and Wealth Tribune.