About 68 years after the creation of the Modern Portfolio Theory, it remains the most popular portfolio management theory among retail and institutional investors today.
This time-tested theory is based on the idea that investors can construct a portfolio of multiple assets that will minimize their risk while maximizing their returns, according to a certain risk level.
Today, the Modern Portfolio Theory has become a fundamental part of our collective global investment mindset.
For many decades, investors of all kinds, no matter their level of knowledge, have learned that their approach will forever be incomplete without a solid grasp of this theory.
“In the world of Wall Street, 60 years is an eternity,” says Wayne Duggan, a contributor at US News.
“So when a concept like Modern Portfolio Theory remains one of the most popular and successful investing strategies 66 years after it was first published, it’s probably a good idea for investors to understand how it works.“
A Nobel-winning solution: The birth of the Modern Portfolio Theory
Before the development of the Modern Portfolio Theory, the dividend discount model was the go-to investment strategy of the day.
This model revolves around the concept that we now call value investing — finding good stocks and buying them at the best price. This approach was the mainstay in the 1930s.
Afterwards, investors built upon value investing by focusing their efforts on conducting fundamental analysis to identify stocks with good performance indicators (in essence, growth potentials). Once they identified these stocks, they waited until it sold for less than its intrinsic value before making a purchase.
What was lacking in this investment strategy was a concern for risk. Not that investors did not understand the concept of risk; instead, there was no quantifiable way to measure the risk or a strategic way to factor it into investment decisions.
American economist Harry Markowitz came on the scene when this was the dominant approach to investing. He proposed a new investment strategy in a paper titled “Portfolio Selection,” published in the Journal of Finance in 1952.
From that paper the Modern Portfolio Theory was born. So ground-breaking was his work that Markowitz would end up winning a Nobel Prize in Economic Studies in 1990!
The world of investing would never be the same.
The need for a risk-averse approach
Before the Modern Portfolio Theory, risk did not feature significantly in investors’ decisions. Investment strategies focused mostly on the fundamentals of the company and its expected returns.
However, Markowitz’s grand discovery was that he recognized that the average investor is risk-averse. In other words, for the same level of returns an investor would be more likely to choose a less risky investment than a more risky investment.
He observed that the investor’s primary goal is to maximize return for a given level of risk or minimize risk for a given level of return.
The Modern Portfolio Theory affirms that the overall risk of a portfolio of investments is lower than the risk of any of the individual investments.
For example, the risk of a portfolio that contains five stocks (say Amazon, P&G, Home Depot, JP Morgan, and United Health Group) is lower than the risk of holding any one of those five stocks in that portfolio without the others. This occurs, however, only as long as the investments are not perfectly positively correlated.
Positive correlation means the two investments move in the same direction – when one rises, the other follows, and vice versa (like the relationship between price and supply).
When two stocks are positively correlated, the same factors affect them in the same way. When they are perfectly positively correlated, the same factors affect them in the same way and to the same extent.
Alternatively, when two stocks are negatively correlated, they are not affected by the same factors. Stock A can be falling while stock B is rising.
For example, let’s say there are two stocks, A and B, where A performs well during the rainy season and woefully during the dry season, and B, which performs well during the dry season and woefully during the rainy season.
If you purchased only A because of its growth potentials and it failed, you will lose your money. Same thing if you bought B. However, by buying A and B in a portfolio, when it is the rainy season, Stock A will counterbalance the loss from Stock B because they are not positively correlated; that is, they are not affected by the same unsystematic risk, and vice versa.
With the focus on individual stocks, your investment risk equals the unsystematic risk of the stock you purchased. That is, all your money is exposed to the idiosyncratic risk of the single stock.
Dividends of correctly done diversification
With Modern Portfolio Theory, you reduce your risk exposure by diversifying it among assets that are not positively correlated.
Even when systematic risk factors (general market factors like inflation, interest rate) affect your investments, they do not affect them in the same way. Therefore, the overall portfolio risk is less than the risk of any single investment.
However, understanding how to pick baskets of assets that are not positively correlated is where most investors get diversification dangerously wrong.
“Investors tend to have a naive understanding of what it means to diversify,” says Dr. Jiro Kondo, Head of Portfolio Construction at Sarwa and Professor of Finance at McGill University. ”If order to properly diversify, you want to find assets that complement each other so that their baskets don’t ‘break’ at the same time. Investors also fail to diversify outside of their domestic market. It turns out international diversification can give you even more bang for your buck in terms of the benefits of diversification.”
In essence, when Modern Portfolio Theory’s principles of portfolio selection are done right, they will protect your investments in every kind of weather and grow your wealth with a minimized exposure to risk.
Because of this, Modern Portfolio Theory has grown into a time-tested strategy that offers the best way to build wealth.
It is also an approach that is naturally linked to one of our favorite Warren Buffet quotes: “Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.”
But Modern Portfolio Theory provides much more than protection from losing money. It also maximizes your returns.
John Wasik, a columnist for Reuters, talking about David Swensen’s management of the Yale University Endowment fund, noted that “his strategy of deploying more than half of the college’s portfolio in alternative assets such as timber, hedge funds, private equity and commodities produced a 15.6 percent annualized return between July 1987 and June 2007, besting the benchmark S&P 500 by nearly 5 percentage points.”
The success of David Swensen would go down in history and become a siren call for the widespread adoption of Modern Portfolio Theory by fund managers across the world.
The rise of passive investing
According to Vikas Badia, an investment researcher at Small Case, there are four key moments of investment history that led to the culmination of the dawn of passive investing.
The first was the Modern Portfolio Theory. The second was the Efficient Market Hypothesis, where Eugene Fama argued that no one could consistently possess the information advantage it takes to beat the efficiency of the market.
The third was Burton Malkiel’s 1973 book, “A Random Walk Down Wall Street,” where he argued that historical prices have no predictive power, and investors are better off buying and holding a diversified portfolio.
The last straw was the stock market crash of 1973. Two years later came Jack Bogle, who created Vanguard Group and launched the first passive index. His business venture would make Vanguard one of the top passive investment icons in the world.
The logic of this outcome is simple. Investors who seek to beat the market almost always fail.
Instead, passive investing now offered an approach whereby investors could track the market’s performance rather than foolheartedly seek to beat it.
Trent Hamm, founder of The Simple Dollar, correctly argues the following:
“Here’s the truth: if it were easy – or even possible – to consistently beat the market, I would do so, but the reality is that no one can consistently and predictably beat any sufficiently large market over an extended period of time. It just doesn’t work.”
Individual investors aren’t the only ones that can’t consistently beat the market. Actively managed mutual funds don’t either. Their funds have trailed the S&P 500 for nine consecutive years.
Indeed, in a bid to beat the market, active investors have been proven to incur higher fees and taxes from consistent purchase and sales of securities.
With passive investment products like ETFs and index funds, fees and taxes are minimal compared to the higher risk some active traders are willing to take on for the “beat the market” returns.
Ultimately, passive investing remedies the cruel math of active investing by tracking the market’s performance and pinning your earnings directly to it.
Critical to the passive investing philosophy is the Modern Portfolio Theory — the use of diversification to minimize risk for a certain level of return.
Putting Modern Portfolio Theory into play
Modern Portfolio Theory is employed by first recognizing that there are different risk appetites among investors.
Risk tolerance can differ based on personality, resulting from emotional and psychological factors.
However, risk tolerance also varies based on the time horizon. For example, a 20-year old should be more risk-seeking than a 60-year old.
The beauty of Modern Portfolio Theory is that you can either start with a defined level of returns or a defined risk level. That is, you can diversify your portfolio to minimize risk for a certain level of returns, or maximize returns for a certain level of risk.
For example, Sarwa, builds portfolios for our clients based on four different risk tolerance levels:
- Very conservative
- Moderate Conservative
Your risk level determines the way your portfolio is diversified. For instance, the very conservative portfolio only has 4% of VTI US Stocks (an ETF) while the growth portfolio has 41%.
Such a system allows you to grow your wealth on your terms by maximizing your returns, according to your risk tolerance.
Financial crises and the Modern Portfolio Theory
Unfortunately, the novice investor tends to buy when the market is up (since that is when everyone is buying) and quickly sells when the market is down (taking the cue from his friend or neighbor).
He/She ends up buying high and selling low, losing his hard-earned money.
These are the people who end up losing a lot of money in the stock market when any crisis hits — recessions or pandemics, for example.
But why do some investors come out of financial crises with little or no harm while others get burnt?
The reason is that the former invest with a strategy, whereas the latter are following the fear-greed cycle.
We are emotional creatures. That is it is important to stick to rule number four: don’t be emotional. It is for the same reason that investors underperform their portfolios.
Adam Hayes, a financial writer with Investopedia, references a study by Ned Davis Research group to make the point that panic in times of crises is the primary cause of investors losing their money.
“Each crisis, markets overreacted and fell too far only to recover shortly thereafter. Those investors who sold on the fear found themselves having to buy back their portfolios at higher prices, while patient investors were rewarded.”
With the Modern Portfolio Theory, investors are able to have a peace of mind even in financial crises because their portfolio is based on a long-term plan and risk is diversified (and, thus, minimized).
An economic crisis might affect your US stocks while your emerging market and developed market stocks are growing. Your airline stocks may be down because of a health crisis, but your technology stocks are covering the base.
Consequently, you can make sound investment decisions without your emotions ruling your head.
Make Modern Portfolio Theory work for you
Modern Portfolio Theory is here to stay because it has been repeatedly tried, tested and approved.
“Modern Portfolio Theory is based on principles that are timeless,” observes Dr. Kondo.
“Diversification is good and diversification benefits can be maximized using a mix of data-driven statistics and analytics-driven optimization. These have been compelling for almost 70 years, and they will remain compelling until the end of time,” he adds.
Ultimately, the Modern Portfolio Theory is a good strategy for every level of investor.
It provides a simple way to diversify your portfolio in a way that matches your risk tolerance. Importantly, by employing passive investing, it also provides stability in financial crises while maximizing returns.
Modern Portfolio Theory is for you if you want to protect your investments, grow them at a maximum return rate according to your risk level, track the market, and keep your cool even in crises.
We at Sarwa use the Modern Portfolio Theory to construct your portfolios and help grow your wealth.
Prior to Harry Markowitz’s publication of Portfolio Selection, investors focused on picking individual stocks with good fundamentals and buying them at bargain prices.
Markowitz’s Modern Portfolio Theory brought the importance of risk to the forefront. This led to the development of an investment strategy that minimizes risk and maximizes returns.
Modern Portfolio Theory is the best way to build wealth because:
- It helps investors diversify their risk and protect their investments
- It enhances passive investing, which helps investors maximize their returns with lower fees and taxes
- It caters to the differing risk tolerance levels among investors
- It fosters a long-term investing strategy that promotes calm during short-term market movements