Investment Risk and Modern Portfolio Theory

Modern Portfolio Theory (MPT) is a financial hypothesis that proposes the use of diversification by rational investors as a means to minimize risk without sacrificing returns. Originally developed by Nobel Prize winner Harry Markowitz and published in 1952, MPT argues that looking at the expected risk and return of a single stock is not enough; investment in multiple stocks is required to realize the full benefits of diversification.

Understanding Standard Deviation

Standard deviation is a statistics term used to measure confidence in statistical estimates. For investors, standard deviation is applied to expected returns. MPT suggests that investors can reduce the standard deviation of returns (that is, make returns more predictable) on a portfolio by including assets that do not move together. As the number of securities held in a portfolio increases, with an appropriate mix of negatively-correlated assets, the variability of the portfolio’s returns diminishes - a decrease in risk.

Types of Risk

Modern portfolio theory describes two types of risks regarding individual stock returns:

Systematic Risk is the risk associated with the overall market. Interest rate changes and the overall health of the economy are examples of this and cannot be diminished through diversification.

Unsystematic Risk is specific to an individual stock. Unsystematic risk decreases as the number of stocks in the portfolio increases. Decreasing this type of risk can make portfolio returns more predictable (less variability).

Modern Portfolio Theory and the Efficient Frontier

The efficient frontier is the term Markowitz used to describe a combination of securities that generate the maximum expected return for a given level of risk. The concept of the efficient frontier was revolutionary when first introduced as it provided clear arguments for the power of diversification.

Modern Portfolio Theory and the Capital Asset Pricing Model

Modern portfolio theory leverages the capital asset pricing model (CAPM) in selecting stocks for inclusion in a portfolio. Analyzing stock beta and the idea of a risk-free return, CAPM calculates a theoretical price for a security for comparison to the market price. If the theoretical price is greater than the market price, that stock could be added to the portfolio.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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