Modern Portfolio Theory (Application With Marketxls Portfolio)

Modern Portfolio Theory

Harry Markowitz introduced Modern Portfolio Theory  in 1951 in his paper “Portfolio theory”. This theory has completely revolutionized the way of what we know of investment philosophy. This theory builds on the foundation that every set of investors, be it risk verse or risk averse, wants to optimize returns with minimum risk as possible. Furthermore, it is the foundation theory on which most economical, financial and investment theories are based upon.

Diversify your risk

There are many investment avenues available, some giving stable while others give higher returns. When you put all your money in one avenue, you are taking a possibly high risk. The possible solution is diversification. This is what Modern Portfolio Theory suggests every investor do. As per MPT, an investor can hold a single asset type as equity, real estate, or mutual fund that is high in risk individually. However, the combination of these asset types balances the risk in a fruitful way. Consequently, even if an investor is putting his money in equities, he should invest in more than one stock to have the advantage of diversification.

Markowitz theory further suggests that stock picking is more of an art,  and should be done by having a portfolio. You can achieve this by choosing the right combination, and rightly allocating one’s saving. If investors are presented with two or more portfolios, each of equal value offering equal returns, MPT envisages on investor preferring the portfolio with less risk. Hence, investors should only take additional risks only with the prospect of getting an additional return. As a result, MPT explains that investors can reduce overall risks by holding diversified asset class portfolios.

A Typical Example

A typical example applying the modern portfolio theory would be :
• Large Cap Stock ( 30% )
• Mid Cap Stock ( 15% )
• Small Cap Stock ( 5% )
• Govt Bond ( 10% )
• Fixed Deposits ( 20%)
• Cash ( 20% )
There are many asset classes. Most noteworthy is that with the time the risk appetite changes as per the investors. While others go with aggressive portfolio allocation,  some have balanced portfolio allocation.

Modern Portfolio Theory Assumptions

• Investors attempt to maximize market returns.
• Investors are rational, and try to avoid risks as much as possible.
• Taxes and brokerage commissions are not considered.
• Investors are not big enough to influence the market.
• Investors can borrow, and lend money as much as they can.
• All the investors have access to the same knowledge platform for making decisions.
• Investors share common views on expected returns.
• Asset returns are normally distributed random variables.

Criticisms of Modern Portfolio Theory

• In the current scenarios of optimizing returns, people are preferring reliance on trends, and psychology rather than on simple buying, holding and selling the portfolio.
• Many investors fail to make the timely investment, even with better portfolio allocation.
• Most investors do not have the knowledge, time, etc to invest,  hence they are not rational to investing approaches, and need professionals at their disposal.

One of the most popular MPT content is Efficient Frontier. Efficient Frontier is an investment portfolio, which occupies the efficient parts of the risk-reward spectrum.

MarketXLS portfolio management

With MarketXLS portfolio management module, you can see the efficient frontier of your portfolio with the various combination of assets in your portfolio.

Investors can use efficient frontiers as the set of portfolio mixes that could possibly result in the most gains, yet with the minimum risk. As a result, we simply take all possible combinations of the portfolio, calculate the risk, and the return, and plot them on a chart.

Then we find out what is the combination of the portfolio, whereas the risk is minimal, but the returns are maximum.

Good Reads:
https://en.wikipedia.org/wiki/Sharpe_ratio
http://news.morningstar.com/classroom2/course.asp?docId=2932&page=4