Modern Portfolio Theory: An Overview
If you were to craft the perfect investment, you would probably want its
attributes to include high returns coupled with little risk. The reality, of course,
is that this kind of investment is next to impossible to find. Not surprisingly,
people spend a lot of time developing methods and strategies that come close
to the "perfect investment". But none is as popular, or as compelling, as
modern portfolio theory (MPT). Here we look at the basic ideas behind MPT,
the pros and cons of the theory, and how MPT affects the management of your
portfolio.
The Theory
One of the most important and influential economic theories dealing with
finance and investment, MPT was developed by Harry Markowitz and
published under the title "Portfolio Selection" in the 1 952 Journal of Finance.
MPT says that it is not enough to look at the expected risk and return of one
particular stock. By investing in more than one stock, an investor can reap the
benefits of diversification - chief among them, a reduction in the riskiness of
the portfolio. MPT quantifies the benefits of diversification, also known as not
putting all of your eggs in one basket.
For most investors, the risk they take when they buy a stock is that the return
will be lower than expected. In other words, it is the deviation from the average
return. Each stock has its own standard deviation from the mean, which MPT
calls "risk".
The risk in a portfolio of diverse individual stocks will be less than the risk
inherent in holding any single one of the individual stocks (provided the risks of