Modern Portfolio Theory
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Modern Portfolio Theory
How do you know you're choosing the right investments for you? It's not all a matter of guesswork. Financial planners have a set of statistical tools that can determine whether your investment portfolio is producing the maximum return for the amount of risk you're willing to accept.
Things To Know
- Modern Portfolio Theory is based on the direct link between risk and reward in investment performance.
- The goal is to create portfolios with the lowest volatility and the highest return.
Who originated it?
Harry Markowitz introduced the Modern Portfolio Theory in a 1952 edition of the Journal of Finance. In 1990, he won a Nobel Prize for his theory on portfolio selection.
What it's all about
Modern Portfolio Theory is based on the direct link between risk and reward in investment performance. When investment prices fluctuate, there is an opportunity to benefit by buying when prices are low and selling when they are high. The greater the difference between the low and high prices, and the more frequently prices change, the greater the opportunity for gain. The frequency and amount of price fluctuation of an investment are called volatility.
Volatility is also a measure of investment risk. The more volatile an investment is, the more risk there is for reward. The Modern Portfolio Theory suggests that there is a relationship between risk and reward and that investors are rewarded for taking investment risk over time.
The goal
The goal of Modern Portfolio Theory is to create portfolios with the lowest possible volatility for any given investment return, and the highest return for any given level of risk. Markowitz showed investors that the information needed to evaluate the risk/return ratio on any portfolio can be determined by using three statistical equations: mean, standard deviation, and correlation.
Where to begin
The first step of Modern Portfolio Theory is to identify an investor's risk tolerance. Risk tolerance is the degree to which an investor can risk his investments to achieve a specific rate of return. If an investor has a low tolerance for risks and wishes to invest more conservatively, he or she is said to be risk-averse. A portfolio is then designed to match the risk tolerance of the investor.
Using the equations of the Modern Portfolio Theory, investors can determine with some precision how effectively their investments are performing given the degree of risk they entail.