Modern Portfolio Theory and The Optimal Portfolio
Modern Portfolio Theory and The Optimal Portfolio
In 1952, Harry Markowitz introduced modern portfolio theory (MPT) as a mathematical model to engineer an optimal portfolio that maximizes expected return, will also minimizing downside risks. For this work, Markowitz won the Nobel Prize in Economics. From here, William Sharpe further built out MPT and his capital asset pricing model to also win the Nobel Prize in his own right, in 1990. Still, modern portfolio theory will always remain controversial because there is no one-size-fits all approach to financial markets.
MPT Assumptions
Modern portfolio theory assumes that all investors are rational – and operate to maximize economic gains, while also mitigating financial risks. Here, in this Universe, all information is disseminated fairly and in a timely manner. Most importantly, financial markets are supposedly efficient, with current prices perfectly reflecting real value. There is no free lunch; and any attempt to game the system is futile.
Historical Data, Risks and Returns
Modern portfolio theory statisticians compile historical data for all competing asset classes, which would include stocks, bonds, money market securities, foreign exchange, and real estate. From here, investment assets may be further sub-divided according to industry, geography, and market capitalization.
We now define risk as possible variance away from the mean historical return through a particular time frame. As a benchmark for the U.S. stock market, the Standard & Poor’s 500 Index has averaged 11% annual returns since its 1957 inception. As risky assets, stocks may be susceptible to crushing 20% losses amid bear market recession, before sharply rebounding through economic recovery for 30% gains.
The Optimal Portfolio
For MPT, the optimal portfolio is the End Game. The optimal portfolio integrates historical returns and standard deviations for competing assets to calculate out a rational point for highest expected returns for minimal downside. Graphically, the X-axis shows deviation, or risk, with the Y-axis showing returns.
To illustrate basic risk versus reward, the capital asset line begins just above origin and extends upward and outward at a 45- degree angle. Meanwhile, the efficient frontier is an arc of portfolios that maximize expected returns for the least amount of risk. The optimal portfolio is the tangential meeting point between the capital asset line and efficient frontier, according to Modern Portfolio Theory.
Controversy
Like all things financial, modern portfolio theory is no stranger to controversy. Any casual observer will note the wild boom and bust swings of financial markets, which directly contradict the idea that all investors are rational at all times. Next, investment records for the likes of Warren Buffett, Peter Lynch, and even the millionaire next door prove the possibilities for beating the market. Ironically, passive, automated investing will be the undoing of the financial system, should everybody decide to sell at once.
MPT economists will spot a $100 bill on the sidewalk and refuse to pick it up. For True Believers, the $100 bill would have already been immediately pocketed, if it were actually worth $100.00.