Modern Portfolio Theory
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.
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Risk and Return
If an investor is willing to take on risk it would only be rational to expect to be compensated for this risk through a higher potential return on their investment. The greater the potential return, the greater the risk.
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Correlation (Co-Variance)
Correlation is a measure of the strength and direction of relationships between random variables (and in our case, different investments or asset classes). Trying to find securities that correlate negatively will reduce the risk of your portfolio.
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Systematic versus Non-Systematic Risk
With respect to any given securities market there exists Sytematic Risk and Non-Systematic Risk. You can all but eliminate non-systematic risk through diversification, but systematic risk is another story.
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Asset Allocation
An Asset Class can be defined as a group of securities that tend to behave in a similar fashion relative to each other in general and are constructed and regulated by a common set of rules.
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Diversifying Across Asset Classes
The advantages of diversification between asset classes are similar to the advantages of diversification between stocks. The Canadian stock market represents only about 3% of the world’s total equity - are you missing out?
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Standard Deviation
According to the Capital Asset Pricing Model (CAPM), risk can be used interchangeably with standard deviation with respect to well diversified portfolios. In other words, risk can be viewed as a measure of portfolio volatility. We have seen, Standard Deviation increases exponentially with Potential Return, but what does this translate to in real world application?
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