Most people who aren’t investment professionals will not have heard of Modern Portfolio Theory (MPT). But if you’ve had any dealings with an investment advisor you will have heard terminology and been asked questions that come straight from MPT. Phrases such as “risk vs reward”, “risk tolerance”, “benchmark”, and “diversified portfolio” all have their origins in MPT.
You don’t need to get into the depths of MPT and its complicated mathematical formulae to benefit from some simple principles that will help you understand how an efficient investment portfolio can be put together and its performance measured and managed.
Whilst not every investment professional agrees with or adheres to MPT, they are all measured against it by their peers and by investors. A very basic understanding of the main ideas of MPT will help you judge whether your investments are performing as well as they can for you and will also help you decide what your “ attitude to risk” really is.
MPT was developed in the 1950s by a young economist, Harry Markowitz as a way of building an investment portfolio to maximise returns for a given level of risk. To do that it was first necessary to determine what is meant by “risk” and what this and the return are compared against. Markowitz’s original theory has been developed over the decades since by various economists, but the basic principles remain the same.
Before Markowitz the focus of most investors was on trying to pick “winning” stocks or bonds and “diversification” might be holding a dozen investments with potential that some of them would become winners.
Markowitz argued that whole portfolio was more important than the “winners”. He also developed the idea that diversification wasn’t just about holding different shares, it was about holding assets that performed differently to each other.
A simple example of this might be holding shares in an umbrella company and an ice cream company. One performs well in the summer and the other in winter. And if there’s a drought the umbrella shares will fall but the ice cream shares will probably go up. This is known as “negative correlation” where two assets go the opposite way in a given situation.
Add to this portfolio the shares in something that is not influenced by weather, say a car company, and you have an asset that is not affected by the same things as the other shares. This is known as “non-correlated”.
A major part of MPT is the idea of “The Efficient Frontier”. On the graph below, the curve represents the theoretical best balance between risk and return. Risk is measured by historic annualised volatility of a particular combination of assets, for example 75% bonds/25% equities and return is measured by the historic compound annualised growth rate. If an actual portfolio’s return and volatility are plotted on the map the position will be above, on or below the line. If it falls below the line it is giving too low a return for the level of risk, and if above the line it is giving an optimal return for its risk level.
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Please Note: The portfolio combinations in this diagram are for illustration only and do not represent real life portfolios
The main point of the Efficient Frontier concept is that in reality, increasing returns does not simply involve taking more risk. For example, an investor choosing an asset mix at the far right of the graph, that is with the highest risk, is not getting twice the return of someone who selects an asset mix with half the risk level. Similarly, the person who, in this example chooses a 100% bonds portfolio could get a significantly better return from the portfolio mix directly above it on the curve, which might be a portfolio that includes other assets than just equities and bonds.
As with most theories, MPT makes a number of assumptions in order to make it work perfectly. The main ones are:
In reality, investors aren’t rational, they’re human. Some will take higher risks than the model suggests they should because they believe they can beat the trend.
And not all information is available to every investor, so asset prices often don’t reflect the full facts.
The theory also relies on historical data to calculate volatility and performance, and unusual real-life events can reduce the effectiveness of this.
A very important addition to the practical use of MPT was economist William Sharpe’s introduction of what became the Sharpe Ratio. This is now widely used to compare an investment fund’s annualised past returns in excess of what is known as the “risk-free rate” (generally accepted as the return on US Treasury Bills), with its volatility. In simple terms a higher Sharpe Ratio signifies that a particular investment has delivered a high return for its level of risk. On the Efficient Frontier graph it would be above the curve.
Sharpe also introduced the concept of a market portfolio which means, in simple terms, a standard portfolio for any asset group. Along with that came the important concept of Systematic Risk versus Specific Risk. The former is one that can’t be reduced by stock selection and would include incidents such as a stock market crash or banking crisis where, in theory all share prices will fall. Specific risk refers to the risk of volatility of a particular asset.
To measure this MPT has developed the terms “alpha” and “beta” to measure investment funds such as unit trusts. Beta is the risk of volatility of the fund relative to a benchmark, such as the FTSE 100 index. If the volatility of the fund is the same as the benchmark it will have a beta of 1. If the number is higher it indicates the fund is more volatile than the benchmark.
Alpha is the historic performance of the fund compared to the benchmark. So if the fund has returned 12% against a 10% return from the benchmark, the beta will be 2 (12% - 10%). If the performance is lower than the benchmark the fund will have a negative alpha. Essentially it indicates how much extra return the fund manager achieves by stock picking, if any.
Using both of these measures indicates, based on past performance, how much return it has delivered for a given level of risk and can be a useful tool to measure how well a fund is managed.
Whilst there are shortfalls in the detail of MPT, the key concepts of are very relevant to individual investors. The key points you can use in choosing investments and then assessing their performance are:
MPT is not a science and is a not a way of predicting how an investment will perform. However, a general idea of its main principles will help you make educated investment decisions, and hopefully will help you understand more the trade-off between risk and return.
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