Modern Portfolio Theory
Modern Portfolio Theory dictates that all portfolios, whether for an institutional investor or individual, should maintain a non-correlated element to help optimise long term returns. In the world of non-traditional investments, such as fine wines, fine arts and so on, Port Funds stands out as the world leader. By using experienced advisory teams, specialists in each sector, Port Funds can provide superior quality potential returns to investors worldwide.
Introduction
Modern portfolio theory is the philosophical opposite of traditional stock picking. It is the creation of economists, who try to understand the market as a whole, rather than business analysts, who look for what makes each investment opportunity unique. Investments are described statistically, in terms of their expected long-term return rate and their expected short-term volatility. The volatility is equated with "risk", measuring how much worse than average an investment's bad years are likely to be. The goal is to identify acceptable level of risk tolerance, and then to find a portfolio with the maximum expected return for that level of risk.
This article covers the highlights of modern portfolio theory, describing how risk and its effects are measured and how planning and asset allocation can help you do something about it.
Modern Portfolio Theory - Build a Portfolio
(Note that risk tolerance is defined as your maximum acceptable value for standard deviation.)
Here are three things you should verify. For (1) and (2), start with a portfolio that includes stocks, bonds and cash.
- If you lower your risk tolerance level, the allocation ratio of stocks-to-bonds will remain constant, and the amount of cash will increase. (Graphically, you're on the straight line joining cash to the Efficient Frontier, and moving to the left.)
- If you decrease the covariance between stocks and bonds, you can allocate more money to stocks and bonds and less to cash, thus raising your rate of return. (This is taking advantage of the curved shape of the Efficient Frontier, stretching it further to the left and tilting the line up. By the way, this demo only lets you decrease covariance to zero, although negative covariance is possible, at least in theory. The size of the covariance will be on a scale roughly equal to the product of the two standard deviations; so for example, if the two investments have standard deviations of 15% and 7%, a large value for the covariance would be .15 x .07 = 0.0105.)
- If you increase your risk tolerance to a high enough level, you'll get a zero-cash portfolio. This means you're up on the Efficient Frontier, but to the right of the point where it intersects the straight line. (In theory you could get up to the line even here if you are willing to hold a "negative" amount of cash, that is, to invest on margin.)
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Conclusions
Everybody can benefit from the first two points:
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The short term dangers of volatility are real; even an excellent long term investment can be a disaster for you if your time horizon is short.
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Diversification reduces volatility more efficiently than most people understand: the volatility of a diversified portfolio is less than the average of the volatilities of its component parts. |
If you're a dedicated stock picker then that's probably as far as you'll go. But if you lean toward mutual funds, you can use the third point:
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A scientific way to attain a diversified portfolio is by using simple tools to choose a small number of low cost funds. The obvious starting point would be a total stock market fund. |
One other point: Modern Portfolio Theory critics like to emphasize a few occasions where people have stretched theory way beyond common sense and lost money. But that shouldn't distract you from the "core" message of Modern Portfolio Theory, that volatility can be planned for, and that diversification lets average investors participate intelligently in the market. |
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