It’s been almost 70 years since the economist Harry Markowitz published his “Portfolio Selection” article in the Journal of Finance. In this article, he outlined a new method of stock market investment called modern portfolio theory. Markowitz went on to receive a Nobel Prize for his revolutionary take on balancing risk and reward. But what is modern portfolio theory, and how does this concept work in practice? Does the application of modern portfolio theory still make sense in today’s post-pandemic economy?
Key takeaways:
- Modern portfolio theory aims to maximize reward while minimizing investment risk.
- It studies how the risk of one investment dovetails with (or contrasts against) others.
- Over a long-term economic cycle, it should deliver strong returns at every stage.
The theory of everything
Modern portfolio theory and investment analysis can be boiled down to a simple philosophy. Every individual investment has an element of risk and an element of reward. By judging the optimal balance between these two opposing elements, you can ensure an investment vehicle performs its best. And by combining other equally well-judged investments, you can create a portfolio that combines the lowest risk and the highest likely rate of return.
Of course, no investment portfolio is risk-free. Modern portfolio theory actively embraces investments that may seem contradictory, such as combining bonds with exchange traded funds. Exchange traded funds tend to do well when inflation is high, whereas bonds struggle in those economic conditions. The opposite is also true, so an investor would benefit regardless of what happens to interest rates. Think of it as putting one egg in every basket.
A game of risk
Modern portfolio theory has been adopted by many investors who are naturally risk-averse. It enables cautious people and companies to maximize their expected return on investment. Rather than focusing on each individual investment’s likely performance, it broadens the investor’s approach to consider how a new asset would combine with existing ones.
Modern portfolio theory is a sophisticated take on the basic principle that investing in multiple asset classes protects against industry- or business-specific shocks. Indeed, it’s the difference between each stock’s intrinsic risk levels that determines the risk applicable to the overall portfolio. Individual investments may be largely unrelated, reacting very differently to certain market conditions.
Modern portfolio theory and investment analysis identifies two types of risk that affect individual stock returns:
- Systematic risks include events beyond personal influence, like interest rate adjustments from a central bank.
- Unsystematic risks affect individual stocks—a proposed takeover or a failed overseas expansion.
A properly diversified portfolio will be able to deliver returns regardless of systematic and unsystematic factors.
A new frontier
This more advanced approach to risk and reward is evidenced in a widely respected concept known as the efficient frontier. It’s a two-dimensional graph showing each asset’s levels of expected risk and expected return on the X and Y-axis, respectively. Joining the various points of each investment creates a curve that demonstrates the optimal balance of risk and reward. And although a degree of variance has to be allowed, combining low-risk/low-return stocks with high-risk/high-return stocks can ensure each element of the portfolio brings something different to the table.
There has been debate around the optimal size of portfolio required to successfully adopt modern portfolio theory. Some experts have recommended 20 stocks for optimal diversity, while others have suggested a hundred may be necessary. Either way, you’ll have to spread your investments across an array of industries, asset classes, and companies. A good place to start is examining Baraka’s stock directory, which provides detailed analysis of individual share performance over varying time periods.
Why doesn’t everyone embrace modern portfolio theory?
The application of modern portfolio theory has undoubtedly proved successful, and it’s routinely embraced by portfolio managers and investors. However, it does have a number of minor flaws:
- There’s little distinction between the risk of many small declines in an asset’s value and one catastrophic crash, making it harder to identify high-risk stocks.
- It requires a long-term approach, achieving consistent results throughout an economic cycle but not necessarily performing optimally in any single phase.
- If you simultaneously bet on the sun shining and not shining, one of your bets will inevitably lose.
- The idea of incorporating high-risk investments into an otherwise relatively low-risk portfolio (to balance out overall risk) can be hard for some people to swallow.
Different approaches
A newer strand known as post-modern portfolio theory has emerged in the last 30 years. It varies on conventional modern portfolio theory by focusing on negative returns as the measure of risk, using advanced concepts like downside deviation to calculate risk-adjusted returns. This is one of many other approaches to stock investing, providing established alternatives to modern portfolio theory. Our recent guide to value vs. growth investing [insert link here once published] demonstrates other ways of compiling a portfolio to achieve profitable outcomes.
