What is Modern Portfolio Theory?

Modern Portfolio Theory is simply an investment strategy that provides the investors with maximum returns with minimum market risk. This theory was developed by Harry Markowitz, an economist, in the 1950s.

Experts are already saying that Modern Portfolio Theory is especially suitable for a year like 2020. The year was marked with volatility in global stocks and related securities. Investors who have applied this theory would be able to achieve their long-term investing goals. They would be able to counter high risk and sleep well at night and avoid panic selling in the worst possible time.

How Modern Portfolio Theory works?

Modern Portfolio Theory suggests diversification of all your securities and asset classes and not putting all your eggs in one basket. It emphasises the importance of portfolios, diversification, risk and the connections among different kinds of securities. That way, the whole portfolio will get balanced in such a way that its risk is lower than the individual risk of underlying assets or investments.

Hence, a well-informed investor will now invest both into low priced stock and high priced stock to maximise possible return over time. As a famous adage says, the whole is greater than the sum of its parts. The risk in a portfolio is always lesser than risk inherent in holding any of the individual stocks, provided the stocks are well-diversified. Also, your portfolio should be able to balance risk and reward in such a way that you get the highest return at an acceptable level of risk.

How do you achieve this?

Strategic Asset Allocation: It’s essential to create a smart portfolio that consists of assets and investments with no direct correlation. They should also not move up or down under the same market conditions. You include these investments in your portfolio in fixed percentages. For instance, stocks are risker investment than bonds, as an asset class. Hence, a portfolio consisting of both stocks and bonds will give a reasonable return for a relatively lower level of risk.

Also, as stocks and bonds are correlated negatively, this Modern Portfolio Theory strategy minimises substantial loss in the overall portfolio, when any one of the assets performs poorly.

In an investment level, foreign stocks and small-cap stocks are usually higher in risk than large-cap stocks. Following Modern Portfolio Theory, you could combine all three to potentially achieve above-average returns compared to a benchmark such as the S&P 500.

A portfolio of mutual funds formed with Modern Portfolio Theory guidelines could consist of the following: 30 percent large-cap stock, 15 percent small-cap stock, 15 percent foreign stock, 30 percent intermediate-term bond, 5 percent cash/money market.

It’s essential to regularly assess your portfolio and rebalance it or bring it back to its original asset allocation. This would help you to overhaul certain assets and keep your holdings in sync with your investment goals.

Two-fund theorem

An investor can hold two separate funds in his portfolio- one with stocks and the other one with bonds. This would help him to simplify the process. They would not have to pick any individual stock. The two-fund portfolio would consist of 50 percent large-cap, mid-cap and small-cap shares, and 50 percent in corporate bonds, short term, medium-term and intermediate-term government bonds.

Features and benefits of Modern Portfolio Theory

– An amateur investor gets benefited by Modern Portfolio Theory as he would not have the ability to speculate and create a portfolio himself. This theory helps him to create a balanced portfolio.

– Spreading your investments across different unrelated asset classes decreases your risk of investment.

– With the help of analysis, the assets that are underperforming or having an excessive risk could be looked into and replaced by a new one.

– Stock investors can use Modern Portfolio Theory to reduce risk by putting a small portion of their portfolios in government bond ETFs.

Disadvantages of Modern Portfolio Theory

– Modern Portfolio Theory may always not seem authentic as it’s not based on current data. Its concepts of risk, reward and correlation are derived from historical data. In today’s day and age, it might not be relevant.

– Modern Portfolio Theory is based on a standard set of assumptions about market behaviour. These assumptions may not be relevant in the current volatile market environment.

– Experts say that Modern Portfolio Theory evaluated portfolios based on variance rather than downside risk.

– It’s a single-period model in a multi-period world.

Are there other alternatives to Modern Portfolio Theory?

Investors who are not comfortable with the buy-and-hold nature of Modern Portfolio Theory can opt for tactical asset allocation. With tactical asset allocation, you can combine the three main asset classes- stocks, bonds and cash- into your portfolio. You could then adjust and balance the assets based on technical analysis and trends to maximise return and minimise risk. Some investors also combine both the approaches and reap the benefits of both strategies.

Conclusion

While diversification is important and a lot of investors swear by Modern Portfolio Theory, it’s still not sacrosanct. Experts say in the world of investment that what matters the most is experience, vision and expert judgement. So, it’s advisable to follow the Modern Portfolio Theory. But it would help if you also went by your gut instinct before making a significant investment. If you need any advice for your investment portfolio, you could always contact the Angel Broking team.