Modern Portfolio Theory: The Basics

Many experienced investors turn to modern portfolio theory when making investment decisions for their money. Modern portfolio theory is one of the most widely used theories in the investment world. Here are the basics of modern portfolio theory and how it applies to the decisions that an investor should make.

Modern Portfolio Theory

Modern portfolio theory has been around since 1952 when it was published in the Journal of Finance as "Portfolio Selection." This theory was invented by Harry Markowitz. He was one of the leading economists in the United States during his career.

Diversification

Markowitz was partly responsible for coming up with the idea of diversification in a portfolio. He theorized that it was not enough to simply look at the risk versus return of a single stock. You need to combine multiple stocks from many different sectors of the market. He noted that when an investor utilized this strategy, they could effectively lower the amount of risk that they are taking on and increase the returns at the same time. Each security that you invest in has a standard deviation which represents the possibility of it deviating from the mean. This is how the theory summarizes risk. By combining many different securities into the portfolio, you can effectively lower the standard deviation and protect your funds better. Therefore, as an investor, it is more important to be good at choosing the right combination of stocks rather than picking individual stocks.

Types of Risk

According to modern portfolio theory, there are two different types of risks that you should be aware of when investing in stocks. You have systematic and unsystematic risk. Systematic risk represents risk that you cannot control under any circumstances. This type of risk represents outside influences on your investment. For example, if another country launches a nuclear missile and it lands on a company that you have invested in, there is no way that you could control this. Other factors that you cannot control include interest rate changes and recessions.

Unsystematic risk is a type of risk that you can actually do something about. With this type of risk, you can effectively eliminate it by purchasing many different stocks. The more stocks that you get in your portfolio, the lower this risk becomes. This value is represented by the amount of change in a stock that has nothing to do with the movements of the market as a whole.

Efficient Frontier

Another important piece of modern portfolio theory is referred to as efficient frontier. This concept deals with the relation to risk and return of a particular portfolio. With every particular level of return, there are many different portfolio combinations that could get you there. However, you want to choose the one that has the lowest risk. When you plot this on a graph, you will be able to see where the efficient frontier line is for a particular group of portfolios. Smart investors will always choose a portfolio that has the lowest risk.

Investment Decisions

You should always strive to look at each investment decision in relation to your portfolio as a whole. Do not purchase stocks just to purchase stocks. You need to purchase them based on how they complement the portfolio that you already have in place.

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