In 1952, Modern Portfolio Theory (MPT) was developed by Professor Harry Markowitz, in his paper ‘Portfolio Selection’ (Journal of Finance 7, no 1, March 1952: 77-91). This basic portfolio model suggested that the variance of the rate of return is a significant measure of portfolio risk under a certain set of assumptions related to investor behavior. Markowitz suggested that to choose profitable investments it is not enough to look at the relationship between risk and return. Investors should focus on the significance of diversification to reduce the total portfolio risk, but they also learn how they can effectively diversify.
The basic assumption of MPT is that investors are willing to maximize their return on investment for a given level of risk. However, investors are fundamentally risk averse, which means that if they have to choose between two assets with equal rates of return, they are more likely to choose the asset with the lower level of risk. Evidence that the majority of investors are risk averse is the fact that they purchase a variety of insurance products outlaying a given amount to guard against an uncertain, possibly larger expense in the future.
Markowitz demonstrated that, because investors are risk averse they need to combine assets into efficiently diversified portfolios. Prior to Markowitz model, investors compiled their portfolios based on the risk-reward relationship of individual securities thus failing to account properly for the high correlation between security returns. However, MPT assumes that portfolio risk can be reduced if investors focus on the variability of expected returns. To achieve that, investors should pick assets that tend to have dissimilar price movements. In other words, MPT assumes that diversification reduces portfolio risk only when combined assets have prices that move inversely.
In effect, MPT teaches investors not only how to select portfolios instead of individual securities, but also how to effectively diversify these portfolios. Many investors wrongly believe that they hold diversified portfolios because they possess different classes of assets such as stocks, bonds, mutual funds and so on. However, although these are different investment vehicles, they are, in effect, the same asset class because they move in concert with each other. For instance, if a bubble bursts out in the stock market, it won’t make too much difference if investors hold stocks or mutual funds in their portfolios. In a market downturn, they will all go down sooner or later. Therefore, proper diversification for MPT is in non-correlated asset classes that move inversely from one another. A diversified portfolio of independent investments offers higher returns with the least amount of volatility.
Besides, by having profoundly shaped how portfolios are managed, MPT suggests that the risk for individual stock returns has two major components:
• Systematic Risk
The systematic risk is associated with cumulative market returns and it is subject to political or economic events. Examples of systematic risk are the interest rates or the recessions and this is why investors cannot really protect themselves against this type of risk. Systematic risk is measured by the beta coefficient (b) that indicates the volatility of a stock relative to the market, which by definition has a beta equal to 1.0. Average-risk securities have beta equal to 1.0 and are typically as volatile as the market. High-risk securities have beta greater than 1.0 and are more volatile than the market, while low-risk securities have beta lower than1.0 and are less volatile than the market. In capital asset pricing model (CAPM), the rate of return required for an asset in market equilibrium is subject to the systematic risk associated with returns on the asset, which is, in effect, the covariance of the returns on the asset and the aggregate returns to the market.
• Unsystematic Risk
Unsystematic risk, also referred to as specific risk, is associated with a specific industry or company. Given diversified holdings of assets, the exposure of an investor to unsystematic risk is small and non-correlated to the rest of the portfolio. Therefore, the contribution of unsystematic risk to portfolio risk is minor and it is not taken into consideration. In well-diversified portfolios, the covariance between individual assets determines the total portfolio risk. Hence, investors have greater benefits from from holding diversified portfolios instead of individual stocks.
To identify the best level of diversification, Markowitz suggested the efficient frontier, which suggests that for each level of return, there is a portfolio that offers the lowest risk and for each level of risk, there a portfolio that offers the highest return. By plotting all these combinations on a graph, the resulting line is the efficient frontier. Portfolios that are positioned on the upper part of the curve are efficient because they provide the maximum expected return at a given level of risk. And these are the portfolios that rational investors should choose.
Overall, MPT demonstrates how portfolio diversification can decrease investment risk. However, to achieve that it often requires investors to invest on perceived risky investments such as futures in order to reduce total portfolio risk. For inexperienced investors this may be a tough task because it requires knowledge of sophisticated portfolio management techniques. Besides, the assumption of MPT that investors can choose non-correlated asset classes that move inversely from one another to achieve proper diversification may collapse in times of market stress. Historically, it has been proven that seemingly non-correlated investments do, in effect, act as though they are related.