Modern Portfolio Theory
Modern Portfolio Theory (MPT) was inspired in part by Harry Markowitz in his 1952 paper titled simply ‘Portfolio Selection’. He later earned the Nobel Prize in Economics in 1990 for this work and it is upon this theory that the core allocation of Preet’s Investment Policy Statements are based.
The basic premise of MPT is that investors may reduce risk for given levels of expected return by creating properly diversified portfolios. More importance is given to diversification within and between broad asset classes over the selection of any individual security in the portfolio. The goal is to select and construct portfolios that lie on an ‘efficient frontier’ which is defined as portfolios that have the least amount of risk for a given level of return as exhibited by the green line in the figure presented here.
(You can click on the figure for a larger view)
In the above figure, any points lying on the green line represent Efficient Portfolios. All points not lying on the green line are deemed to be non-efficient portfolios. The total grey line represents portfolios with increasingly less fixed income allocations. For example, Point D (the start of the grey line) represents a 100% fixed income portfolio. Point C represents an 80% fixed income, 20% equity portfolio and Point B represents a 30% fixed income, 70% equity portfolio and so on.
Point A - A Non-Efficient Portfolio. By adjusting the asset allocation and an investor could reduce the risk of the portfolio for the same level of return (Point C), or the investor could adjust the asset allocation to increase the return for the same level of risk (Point B).
Point D - A Non-Efficient Portfolio. Modern Portfolio Theory has shown that a 100% fixed income portfolio (Point D) actually has more risk and less expected return than a portfolio that is 80% fixed income and 20% equity (Point C).
