Modern Portfolio Theory
Investment Planning the Nobel Prize Way
Modern portfolio theory was originated
by Harry Markowitz in 1952. While investors before then knew intuitively
that it was smart to diversify (ie. Don’t "put all your eggs in one basket.")
Markowitz was among the first to attempt to quantify risk and demonstrate
quantitatively why and how portfolio diversification works to reduce risk
for investors.
In 1990, he shared
a Nobel Prize with Merton Miller and William Sharpe for what has become
a broad theory for portfolio selection.
Portfolio theory explores how risk
averse investors construct portfolios in order to optimize expected returns
for a given level of market risk. The theory quantifies the benefits of
diversification. Out of a universe of risky assets, an efficient frontier
of optimal portfolios can be constructed. Each portfolio on the efficient
frontier offers the maximum possible expected return for a given risk
level.
* An efficient frontier is a set
of portfolios that each maximize expected return for a given level of risk, as indicated by the red line in the above graph.
Investors should hold one of the
optimal portfolios on the efficient frontier and adjust their total market
risk by leveraging or deleveraging that portfolio with positions in the
risk-free asset.
Based upon strong simplifying assumptions,
a capital asset pricing model concludes that the market portfolio sits
on the efficient frontier, and all investors should hold that portfolio,
leveraged or deleveraged with positions in the risk-free asset.
Portfolio theory provides a broad
context for understanding the interactions of systematic risk and reward.
It has profoundly shaped how institutional portfolios are managed, and
motivated the use of passive investment management techniques. The mathematics
of portfolio theory is used extensively in financial risk management and
was a theoretical precursor for today's value-at-risk measures.
Modern portfolio theory has been
applied by institutional investors for years. Mutual funds coupled with
modern computing power have opened the door for the smaller investor to
benefit from sophisticated analysis as well. Mutual funds provide a vehicle
for an individual investor to participate in diversified investments in
specific asset categories. Modern computing power allows financial planning web sites like YKConsultancy to offer personalized asset allocations. |
