Modern Portfolio Theory

In 1952, a guy by the name of Harry Markowitz published an article that put forth a new idea about how to be successful as an investor, based on historical data of the financial markets. His theory, called Modern Portfolio Theory, would eventually become recognized as a ground breaking shift in the investing world. Markowitz won (actually shared) the Nobel Prize in Economics in 1990 for his development of MPT. What is it and how does it affect you? Keep reading….

Breaking From Tradition

We tend to think that there is an even balance between risk and return. Traditionally, the higher risks you take, the higher your returns over time will be. This can be represented by a linear graph pitting return vs. risk and showing a direct correlation.

However, the #1 rule of statistics is that correlation does not necessarily mean causation. In other words, just having high risks doesn’t mean you’re going to get great returns. If you invest a ton of money in your cousin’s garage based, app developing, start up company, you might never see your money back, no matter how long you wait.

Markowitz showed that the correlation between risk and reward is more of a curved line, which he called “The Efficient Frontier.” When a portfolio is on or near the curved line, it is said to be efficient, meaning it is getting a large amount of return for the amount of risk it is taking. The goal, then, is not to just maximize returns in an absolute sense, but to maximize returns relative to the risk that any given portfolio is exposed to.

This represents another break from tradition and a paradigm shift in investing. Normally, people are just concerned about the amount of returns they get. They want to “beat the market.” By focusing on outperforming the average of everyone, you have to pick more winners than losers, and your winners have to win more than your losers lose (I’ll explain later why this is a rigged game). However, MPT recognizes that there are too many variables to keep track of, and too many we have no control over. Let’s say a clothing company shows only signs of incredible growth moving forward, you buy their stock, and a pesticide-resistant insect destroys that year’s cotton crop. There’s no way to account for that. But, if you also own companies that produce polyester, nylon, international cotton, wool, and other materials, as well as owning pesticide and agricultural companies that work to eliminate the problem, then you benefit by having your hand in all aspects of the economy.

This is what MPT tries to do – own everything, recognizing that when one kind of investment goes down, there is somewhat of an opposite and equal reaction – other kinds of investments go up. Economic situations that are bad for some people (like low interest rates for savers) are good for other people (like low interest rates for borrowers).

Forget About Beating the Market

There is no end to people either saying that they can “beat the market” or looking for investments that “beat the market.” When someone uses that phrase, you should ask them, “What market?” There is no measure of “the market,” only certain fractions of the market. The S&P 500 is an index of just 500 of the largest US companies. Its not the whole market. The Dow is only 30 companies. When your portfolio is made up of a variety of US and foreign companies and governments, and you compare it to the S&P 500, you’re comparing apples and oranges.

Furthermore, the S&P 500 is an index, meaning its not a mutual fund or ETF (exchange traded fund, like a mutual fund, but cheaper). There are mutual funds and ETFs that mimic the holdings of the index, but they will never outperform the index for one simple reason: fees. The index has no trading costs, no management costs, no advisor fees, while all mutual funds and ETFs do. This is what I mean by “beating the market” as a rigged game. Fees and costs in the real life mutual funds make it an uphill battle to beat any index that doesn’t have those costs.

Following Modern Portfolio Theory changes your goals. Rather than trying to beat the market, it simply rides the wave of the market by passively investing to minimize costs. The next time you’re tempted to pick a stock or follow some analyst’s recommendation, think about the risks involved, and how little you actually know about the stock or where its headed.

Tons of information is available on the web about Modern Portfolio Theory. I pulled much of the information in this blog post from http://www.rebalance-ira.com, http://economistatlarge.com, and http://www.smart401k.com.

-N&$

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One thought on “Modern Portfolio Theory

  1. Pingback: No Place to Hide | Numbers And Sense

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