Modern Portfolio Theory
Breaking down Modern Portfolio Theory
The year is 1952. Roughly 4.2% of the United States population invests in the stock market. Majority of the country considers investing a way for affluent individuals to gamble with their ample means. The Fed lifted the cap on interest rates one year prior, and stocks are now outperforming bonds by 25 percentage points. Index investing has yet to regain popularity since the crash of 1929, and international investing is nonexistent.
Meanwhile, 25-year old Harry Markowitz is putting together his doctoral thesis. He comes across an idea that will (over time) change the landscape of finance and earn him a Nobel Prize.
The idea behind his seminal article, Portfolio Selection, was born of coincidence. While in a waiting room, a broker casually suggested Markowitz apply his studies in statistics to the stock markets. After reading The Theory of Investment Value by John Burr Williams, Markowitz considered two ideas that were, to his disbelief, being ignored: risk and diversification.
Modern Portfolio Theory operates under the following assumptions:
- 1.Investors are risk averse
- 2.Investors are rational
- 3.All investors have access to the same information
- 4.Returns are normally distributed
Modern portfolio theory (MPT) provides investors with a portfolio construction framework that maximizes returns for a given level of risk, through diversification. MPT reasons that investors should not concern themselves with an individual investment’s expected return, but rather the weighted average of the expected returns of a portfolio’s component securities as well as how individual securities move together. Markowitz consequently introduced the concept of covariance to quantify this co-movement.
“Markowitz reasoned that investors should not choose portfolios that maximize expected return (in isolation), because this criterion alone ignores the principle of diversification. He proposed that investors should instead consider variances of return, along with expected returns, and choose portfolios offering the highest expected return for a given level of variance.”3 These portfolios were deemed “efficient.” For given levels of risk, there are multiple combinations of asset classes (portfolios) that maximize expected return. Markowitz displayed these portfolios across a two-dimensional plane showing expected return and standard deviation, which we now call the efficient frontier. Though all portfolios along the efficient frontier are “efficient,” the portfolio that maximizes returns for a particular investor’s level of risk is known as the Optimal Portfolio.
An Efficient Frontier
Those familiar with the philosophies and solutions here at Windham can likely deduce the impact of MPT on investing today. The application of modern portfolio theory is known as mean-variance optimization, which plays a key role in investing for both individual investors to large institutions.
However, it took a long time for MPT implementation across the field. The initial article, Portfolio Selection, was laden with complex graphs and equations that proved difficult for practitioners to understand. For decades, investors clung to their “gut instincts” in investing, and as a result MPT remained stuck inside academic circles. In 1970, William F. Sharpe published his book titled Portfolio Theory and Capital Markets, which introduced the Capital Asset Pricing Model (CAPM) and built on Markowitz’s theory. Together, CAPM and MPT contributed to the rise of index investing.
In 1990, Harry Markowitz, William Sharpe, and Merton Miller, won the Nobel Prize in Economics. Their innovative work paved the way for quantitative financial analysis as well as many of the investing trends we use today. Markowitz’s belief in diversification has influenced the economy worldwide, as alternative asset classes such as publically traded REITs and commodities have proven to be efficient ways to diversify portfolio risk.
The concepts introduced in Markowitz’s early work provided the foundation for the analyses and investing practices that we use today. His work has especially influenced the work we do at Windham, as we provide our users with the tools for a comprehensive understanding of risk throughout the asset allocation and portfolio construction process.
- 1.Stocks Then And Now: The 1950s And 1970s. (2008, October 01). Retrieved March 23, 2018, from https://www.investopedia.com/articles/stocks/09/stocks-1950s-1970s.asp
- 2.Lauricella, T. (2012, February 19). ‘Retro’ Investing-Look Back to Get Ahead. Retrieved March 25, 2018, from https://www.wsj.com/articles/SB10001424052970204880404577227043217645160