Modern Portfolio Theory

While simple portfolio diversification was considered a reasonable practice before the early 1950s, Harry Markowitz was the first to attempt to quantify the role of risk as it relates to diversification and its effect on portfolio returns. Almost four decades later, in 1990, Markowitz, William Sharpe, and Merton Miller won the Nobel Memorial Prize for Economics for their work in developing Modern Portfolio Theory (“MPT”) as a portfolio management technique. MPT has been widely used to develop and manage investment portfolios for large institutions, as well as individual investors.

Active investors and active fund managers attempt to pick securities and time markets through their respective study of the underlying fundamentals of individual stocks, with less focus on the actual markets. Conversely, adherents to MPT pay very little attention to individual securities and instead focus on the behavior of broader markets which is the product of the actions of its participants. The MPT group accepts that markets are efficient and that market efficiency is derived from the actions of active participants. To believe that markets work efficiently, one must believe that some of the constituents of the market are informed, have studied the fundamentals of the individual securities and are acting rationally. Here we can refer beck to Samuelson’s “Efficient Market Hypothesis” which states that a stock’s price, which is the product of informed market participants, is the best determinant of value.

Through Modern Portfolio Theory and the acceptance that “markets are efficient” we arrive at the conclusion that investing in the entire market of stocks and/or bonds is a more effective strategy than a) attempting to analyze and pick individual securities; and b) attempting to time the entry and exit points of those investments.

Trovena’s goal is to determine your acceptable level of risk, then to match that level of risk to the highest expected returns; MPT is paramount to this process.

There are four components to Modern Portfolio Theory:

1. Investors inherently avoid risk. Investors are often more concerned with risk than they are with reward. Given the choice of two securities which offer the same return, the investor will choose the security which offers less risk. Rational investors are not willing to accept additional risk unless the level of return compensates them for the risk.

2. Securities markets are efficient. The “Efficient Market Hypothesis” states that while the returns of different securities may vary as new information becomes available, these variations are inherently random and unpredictable. Assets are re-priced literally every second of the day according to what news is immediately available. As new information enters the market it is quickly reflected in the prices of securities, and thus temporary pricing discrepancies are extremely difficult, if not imposible, to exploit for profit. Advanced information dissemination technology and increased sophistication on the part of investors are actually causing the markets to become even more efficient, further complicating attempts to exploit price fluctuations.

   The implications of the Efficient Market Hypothesis are profound for investors. It implies that one should be deeply skeptical of anyone who claims to know how to “beat the market.” One cannot expect to consistently beat the market by picking individual securities or by “timing the market”.

   The Efficient Market Hypothesis is at odds with traditional investment strategies. However, it has been supported by numerous academic studies, both theoretical and empirical. These studies show, among other things, that the risk-adjusted returns achieved by most professional investment managers are no better than those of the market as a whole, and many times inferior. This is primarily due to expenses and taxes incurred with active management. That’s the bad news for active fund managers and investors. The good news for all investors is that the rate of return of the capital markets is exceptionally good, yielding 10% or more annually over time.

3. Focus on the portfolio as a whole and not on individual securities. The risk and reward characteristics of all of the portfolio’s holdings should be analyzed as one, not separately, using the knowledge stocks offer higher returns than bonds, small stocks offer higher returns than large stocks and value stocks offer greater returns than growth stocks, all with their respective commensurate risk levels. An efficient allocation of capital to specific asset classes of stocks and bonds is far more important than selecting the individual securities.

   

   Source: “Determinants of Portfolio Performance” published in the Financial Analysts Journal (August 1986) by Gary P. Brinson, L. Randolph Hood, and Gilbert Beebower.

   As the chart shows, your asset allocation can determine over 90% of the performance variation of your investment portfolio. How your investment dollars are allocated far outweighs the potential effects of individual security selection and market timing.

4. Every risk level has a corresponding optimal combination of asset classes that maximizes returns. This is called the “Efficient Frontier”. Portfolio diversification is not so much a function of how many individual stocks or bonds are involved, but the lack of correlation of one asset to another. The higher a correlation between two investments, the more likely they are to move in the same direction. A portfolio of many different oil company stocks is highly correlated but poorly diversified. In this example, a disruption in oil supply will likely have a similar effect on all of these stocks. A portfolio of oil company stocks and alternative energy stocks is not as correlated and an oil supply disruption would probably have a different effect on oil company stocks than alternative energy company stocks. A higher lack of correlation equates to a greater level of diversification.

   The efficient frontier represents the range of hypothetical portfolios that offer the maximum return for any given level of risk. Portfolios positioned above the range are unachievable on a consistent basis; portfolios below the efficient frontier range are too risky based on the amount of reward offered and thus inefficient. The goal is to find the point along the efficient frontier which offers the maximum return at the risk level appropriate to an investor’s risk tolerance.

   

   The portfolio represented by point A is inefficient because portfolios exist with the same value but less risk (Portfolio B) and portfolios with the same risk but more value (Portfolio C) as well as portfolios with a combination of these two conditions (Red Area). The Efficient Frontier, as originally defined in Modern Portfolio Theory, is a line that represents the continuum of all efficient portfolios relative to risk and value.