Modern Portfolio Theory is an investment theory that was put forward by famed economist Harry Markowitz in 1952. He stated that risk-averse investors are able to create portfolios that will allow them to maximize their expected return based on their level of market risk. He emphasized that the higher the risk, the higher the return. His investment theory was a breakthrough in portfolio management and demonstrated that purchasing a basket of securities would result in lower volatility than purchasing just one, the essence of diversification.
Modern Portfolio Theory & Risk Aversion
Modern Portfolio Theory states that the investors, at heart, are risk averse. If they had to choose between two portfolios that offer the same rate of return, a rational investor would choose the one with the lowest risk. Investors would be willing to take on higher risk if only it can yield higher expected returns. However, each investor will evaluate the trade-off differently based on their risk appetite and their attitude towards risk.
Expected Return
Modern Portfolio Theory states that the expected rate of return of a portfolio is a weighted average of individual returns.
Portfolio Weighting Example: You have $2,000 to invest in Pepsi and Coca Cola stocks. If you invest $1,000 in Pepsi and $1,000 in Coca Cola, then the weight of Pepsi is $1,000/2,000 = 50%. The weight of Coca Cola is $1,000/$2,000 = 50%. This is an equally weighted portfolio of two stocks.
Return on Portfolio with Two Assets: You have invested $3,000 in Pepsi stock and $2,000 in Coca Cola. the expected return on Pepsi is 4.5% and the expected return on Coca Cola is 5.5%. What is the return of your total portfolio?
First, you’ll notice that Pepsi makes 60% of your total portfolio while Coca Cola makes up 40%. Multiply the weight of the portfolio by the rate of return.
(0.60)*(4.5%)+(0.40)*(5.5%) = 4.9%
You may not have only two holdings in your portfolio. You may have 10+ holdings. By multiplying the weight of each asset class by the expected rate of return, you’ll find the expected rate of return of the total portfolio.
Standard Deviation
Standard deviation is the statistical measure of risk or uncertainty that measures the various possible returns. The larger the standard deviation, the great dispersion of expected returns and the greater the risk or uncertainty.
Standard deviation is also often referred to as total risk, which includes both market risk and specific business risk. For example, if we have two portfolios, Portfolio A and Portfolio B, each with a expected return of 10% but with different standard deviations, which portfolio would you choose?
Diversification
Markowitz preached that through diversification, an investor can reduce their portfolio risk by including investments that are not correlated with one another. He mentioned if two securities have a correlation of 0 – means that they are perfectly uncorrelated.
Correlation is simply the likelihood of two investments moving together in harmony. The higher the correlation, the more likely they are of similar characteristics. For example, the stock of Coke and Pepsi would be positively correlated as they’re in the same field and industry. These investments would have a correlation of +1.
Negative correlation is when two securities would move in opposite direction. For example, when a recession hits, gold would go up, financials would go down. These type of investments would have negative correlation of -1.
There are various strategies that one can embrace in order to diversify their portfolios. These strategies can be used in combination. You may diversify your portfolio via:
- Asset Class – having stocks and fixed income in your portfolio will diversify your portfolio
- Company Size – large cap companies are more stable than small cap companies.
- Industry – adding companies in various industry will allow your portfolio to withstand business cycles
- Geographic – investing in different countries can reduce the risk of your portfolio
- Management Style – depending on the portfolio manager’s mandate, diversification can be achieved. (Value vs. Growth)
- Maturity – Bond laddering or GIC ladder can add diversification to a portfolio. Buying fixed income instruments at different intervals
- Credit – Including companies with strong credit rating and low credit rating such as high yield bond.