Modern Portfolio Theory (MPT) is not some-thing that I talk to my clients about in detail, and you may well be thankful for that.
But there is no doubting the powerful influence MPT has on the creation of an effective investment strategy.
Harry Markowitz developed MPT in the early 1950’s. He showed how and why investment diversification works to reduce the risk of a portfolio of investments.
Before Markowitz investors had known intuitively that it was prudent to diversify but there was no clear rules for how this should be done.
As a result, investors were diversifying on an ad-hoc basis and the end result was not necessarily an “efficient portfolio”.
Risk and return are related. Markowitz’s view was that investors are generally risk averse and therefore that they will want to be compensated with higher returns in order to accept higher risk.
This means that investors will not just go for the maximum return they can get - they will take into account the risk. We all have different levels of tolerance for that risk.
Markowitz was able to show that the expected return of a portfolio of investments was merely the average of the individual investments.
But risk was a different story. Markowitz found that investments could be combined in such a way that the risk of the portfolio as a whole was less than the risk of each individual investment when added up.
Where does this lead - that the expected return did not alter when investments were combined together but the overall risk of achieving that return decreased.
Clearly this is a desirable situation to be in.
If the process is done correctly the result is an “efficient portfolio” - one which has the “smallest portfolio risk for a given level of expected return” or alternatively “the largest expected return for a specified level of risk”.
While it might be obvious that we all should wish to own an efficient portfolio (maximise our return for a given level of risk) often that is not the case when investors put together their own portfolios.
Often in do-it-yourself portfolios the level of risk taken to earn a certain level of expected return is much higher than it needs to be.
One of the more important aspects of the work we do for you involves Modern Portfolio Theory and the creation of efficient portfolios.
