Everyday Financial Guide

January 9, 2012

What is Portfolio Theory

Filed under: Investing — Tags: , , , , , , — thefranksteak @ 12:24 pm

Portfolio theory or modern portfolio theory (MPT) is the belief that the risks inherent in investment can be reduced through systematic diversification. In simple English this means investing in several different instruments in order to avoid losing all of your money.

MPT investors believe that a mathematical formula that outlines a diversified portfolio that will eliminate almost all risks can be created. This notion was first advanced in 1952 by Nobel Prize winning economist Harry Markowitz. Markowitz was the first to advance the idea that investment decisions should be based upon everything in the portfolio rather than individual stocks or bonds.

The Efficient Frontier

Markowitz and two partners William Sharpe and Merton Miller (the three shared a Nobel Prize for Economics) set out to devise a “mathematics of diversification” that could be used to create effective portfolios. They created a mathematical model designed to show investors how to arrive at the “efficient frontier.”

The efficient frontier would be a portfolio that evenly balanced risk and reward. If one stock in the portfolio lost money that loss would be covered by gains in another. Most mutual funds today and many indexed investments are designed to use MPT to arrive at this state.

In a portfolio created with MPT all the investments meet the criteria of the mathematical formula used. If it works properly the super efficient portfolio would never lose money. This is also called efficient market theory or the idea that the market behaves in a rational or efficient manner so its fluctuations can be predicted with mathematical models.

Criticisms of Portfolio Theory

Portfolio and efficient market theory have been heavily criticized over the years. Value investors such as Benjamin Graham and Warren Buffett believe that the market is irrational so its behavior cannot be predicted. Instead they believe that each investment must be judged on its fundamental or intrinsic value.

Another criticism is that the portfolio theory cannot take every risk or probability into account. There is simply no way that analysts can predict every event or development that could affect the market or an investment’s behavior.

Philosopher and hedge fund trader Nassim Nicholas Taleb believes that extraordinary events that affect the market are common place. Taleb thinks that no risk management model based on a prediction of a steady or efficiently working market is valid.
Taleb’s belief is that game changing events called Black Swans are more common than people think. These events can upset everything including the market so no risk management model based on a steady market can work. Under this theory a portfolio might operate efficiently for awhile but sooner or later some outside factor would upset its operation.

Taleb created the phrase Black Swans to describe highly improbable events that can disrupt everything. Such events can cause the entire market to collapse or lose value. Taleb reportedly made large amounts of money by betting against the market during the economic meltdown of 2005-2010. Many of the investments including 401Ks and mutual funds that lost a large amount of their value during this period were based on Modern Portfolio Theory.

Is It Valid

The book is still out on modern portfolio theory. The idea behind it is a sound one but its performance in the actual market has not lived up to some of the claims for it. Investors should definitely diversify their portfolios but they should also realize that diversification will not eliminate all risks. Instead it simply reduces the risks by making them less likely.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuity Definition, Annuity Rate, and Best Annuity Rates.


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