Modern Portfolio Theory – Explained in 4 Minutes
Modern Portfolio Theory or MPT says that it’s not enough to look at the risk and return of a single security. Make a portfolio, diversify, like the phrase don’t put all eggs in one basket, but select the right set of eggs.
Your risk as an investor is that the return on your investment will be lower than expected. According to MPT, this risk is the deviation from the average return. Each security has its standard deviation from the mean.
If an asset has an expected return of 8% and risk of 10%, you can observe returns between -2% and 18%.
Suppose two portfolios A and B have an expected return of 10% each. But A’s risk is 8% while that of B is 12%. Looking at these two portfolios you would think, both give the same returns, but A has lower risk, I’ll buy A.
But if you’re adventurous, you’d say portfolio A can return between 2% and 18%, while B can give between -2% and 22%. You might choose B.
Portfolio B offers a chance of getting 22% return but there’s also the possibility that instead of making gains, you might end up losing money. The additional return is compensation for additional risk. Hence the notion, the higher the risk the higher the return.
How do you make an optimal portfolio?
By selecting the right combination of assets. If two assets are similar, then their prices will move in a similar pattern. Say, two Exchange Traded funds or ETFs from the same economic sector tend to show similar price movement, while, ETFs from different sectors show dissimilar price movements, as they lack correlation, making them a suitable set of eggs for your basket.
Correlation is measured on a scale of -1 to +1. +1 indicates positive correlation where prices of two assets move par-for-par, while -1 shows negative correlation; prices move in opposite direction.
If you put two assets with correlation of +1 in a portfolio, the risk they bring to portfolio will be the sum of the weighed risk of individual assets. However, if you put a pair of assets with correlation of less than 1, then the risk of the resulting portfolio will be less than the sum of the weighed risk of individual assets.
By selecting different asset combinations you can achieve every risk to return combination in a portfolio.
And this brings us to the efficient frontier, which is a graphical representation of different combinations of assets to achieve an optimal level of return at any given level of Risk.
With risk on X-axis and return on Y-axis, this hyperbola shows all outcomes for various portfolio combinations of risky assets. This Straight Line is the Capital Allocation Line, which represents a portfolio of all risky assets and the risk-free asset, like government bonds.
Tangency Portfolio is the point where the portfolio of risky assets meets the combination of risky and risk-free assets. And this portfolio maximizes return for a given level of risk.
As you move towards the right along the lower part of the hyperbola you get lower returns at higher risk. Do the same along the upper part and you get higher returns at higher risk.
The take away is that an asset's risk and return should not be assessed by itself, but by how it contributes to a portfolio's overall risk and return.
We utilize Modern Portfolio Theory in our module 1, which has allowed us to achieve such returns…
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