Investment Tools » Portfolio Planning Calculator » Modern Portfolio Theory
Modern Portfolio Theory
Introduction
While modern portfolio theory has been around for a while, it is but one of many tools and processes used by investors for managing their portfolios. It has its detractors as well as its disciples. The explanation provided here is very brief and there is plenty of information provided elsewhere on the Internet for those that wish to pursue the subject further. (Just use your favourite search engine!).
Modern Portfolio Theory is a sound method for many investors to establish a disciplined approach to investing. Modern Portfolio theory has been used in establishing the Portfolio Design Calculator featured on these web pages.
The actual process used for establishing optimal portfolios uses statistical data and programmes which are not described in detail here. This is a brief introductory overview only.
A brief overview
Basic portfolio theory was originated by Harry Markowitz (Nobel Prizewinner) in the early 1950's. 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.
He was also the first to establish the concept of an "efficient portfolio". An efficient portfolio is one which has the smallest attainable portfolio risk for a given level of expected return (or the largest expected return for a given level of risk).
The process for establishing an optimal (or efficient) portfolio generally uses historical measures for:
for each asset to be used in the portfolio (or series of portfolios).
Note: historical measures are used as a proxy for expected future returns which may or may not be true, particularly over the short term. History is a better indicator if used over the long term.
Asset Allocation
While this process can be performed on any portfolio with two or more assets, it is most commonly applied to asset classes. Asset allocation is the process of allocating funds to each asset class. Much analysis has been performed which indicates this may be by far the most important decision. (May account for up to 90% of the return of the portfolio).
Each asset class will generally have different levels of return and risk. They also behave differently. At the time one asset is increasing in value, another may be decreasing or, at least, not increasing as much and vice versa. The measure used for this phenomenon is called the correlation coefficient.
Correlation coefficient is a measure of the degree to which two assets (or investments) move together.
The value of the correlation coefficient ranges from -1 to +1. Assets which have a correlation coefficient of -1 are perfectly negatively correlated. ie. Their values move simultaneously in opposite directions and magnitude.
For a value of +1 they are perfectly positively correlated. ie. Their values move simultaneously in the same direction and magnitude.
A correlation coefficient of 0 indicates there is no relationship at all.
In reality, most assets have some positive correlation, although it may be very low.
Returns is a term that is understood by most investors. Total return is a measure of the combined income and capital gain (or loss) from an investment. This is usually expressed as a percentage which may be annualised over a number of years or represent a single period.
Risk (Standard Deviation of Returns)
While there are many types of risk and different methods of measuring them, the Standard Deviation of (historical) returns is probably the most common measure of the risk of listed securities and portfolios. It is a statistical measure which measures the variability of returns (about the mean or average). The higher the standard deviation, the more uncertain the outcome over any period.
Standard deviation is very useful in that it enables us to compare the riskiness of different types of investment. For example shares against bonds.
By computer processing the returns, risk (standard deviation of returns) and correlation coefficients data, it is possible to establish a number of portfolios for varying levels of return, each having the least amount of risk achievable from the asset classes included. These are known as optimal portfolios.
The investor then simply has to choose which level of risk is appropriate for their particular circumstances (or preference) and allocate their portfolio accordingly.
Note: This graphic representation is not intended to indicate the precise risk or returns that may be attained by portfolios available on MoneyOnline or any portfolio.
Assumptions
Modern portfolio theory makes some assumptions about investors. It assumes they dislike risk and like returns, will act rationally in making decisions and make decisions based on maximising their return for the level of risk that is acceptable for them.
When making asset allocation decisions based on asset classes it is assumed that each asset class is diversified sufficiently to eliminate specific or non-market risk.