It has become part and parcel of today's world that the modern portfolio theory principle must be applied to the work system of the companies and investment institutions.
Now, it is almost impossible or even not wholly possible for any investment in the present world. However, modern portfolio theory becomes applicable since it brings some added monetary returns and reduces some of the possible risks.
The economist who codified this theory is Markowitz. The theory aims to serve as a tool for balancing return and risk or expected loss in any investment model.
Indeed, so critical is this thinking and application of principles in such portfolios for all forms of investments that the investor must become familiar with the initial asset Management Process of such portfolios before an understanding of the road map to achieving investment success, whether by economic returns or the number of possible risks. Learn New Techniques for Investment and Master Your Portfolio Management Skills in Advance with Advanced Skills of Portfolio Management Course.
According to modern portfolio theory , an investor is supposed to select a portfolio so that the greater part of its return would be obtained within the levels of risk acceptable to the investor. This is the mathematical portfolio construction method for investments to maximise the expected return of all investments at the given level of risk.
The concept was developed by Harry Markowitz, an American economist in his paper Portfolio Selection published in the Journal of Finance in 1952.
For his work on modern portfolio theory, a Nobel Prize was later awarded to him.
Diversification is a crucial pillar of MPT theory. Investments are classified as either risky and having the potential for great returns or low risk and low returns. According to Markowitz, it would be possible for investors to achieve the best results by providing the best combination of the above two according to one's perceived tolerance for risk.
At the heart of Modern Portfolio Theory is the premise that risk and return are intimately linked. Investors are assumed to choose the course of action providing the generally highest possible return for a particular level of risk exposure. MPT puts forward some valuable and important concepts in its framework for arriving at such decisions:
In MPT, risk and return are held to be inextricable. Every investment is risky, but the point is to learn about that risk and manage it. Risk is measured in MPT by standard deviation of returns, and return is the expectation of the average outcome over the period in question. From both standpoints, it is necessary to optimise them all by matching risk with expected return.
MPT sways one of its greatest contributions in diversification. Holding diverse assets in a portfolio reduces its total risk. More than that, MPT highlights that the risk of a portfolio is not merely the sum of the risks of individual assets. It is possible to reduce a portfolio's total risk without giving up return by pulling together assets with low or negative correlation.
A distinctive feature of MPT is this Efficient Frontier, which is a graphical representation that shows portfolios with the "'highest'" expected return for every level of risk. Portfolios that fall in this curve are considered efficient portfolios as they are getting the highest return, which is associated with risk taken. Ideally, every investor should be striving to build portfolios that fall within the efficient frontier.
The premise includes the existence of risk-free assets with which to create an optimal mix of risk and return together with an investment portfolio. This is with the long-term end in which the capital market line is created for risk-return trade-off as investments' risky portfolios combined with a risk-free asset.
Correlation is the measurement for how the two assets are moving in relation to one another. A negative correlation especially helps to take care of risk when it is time to construct a portfolio. MPT uses covariance also to measure how asset returns move together.
It is suitable for investors developing diversified portfolios. It became more relevant when it was possible to use it in conjunction with future exchange-traded funds towards reaching more asset classes for an investor.
For instance, stockholders can lower risks by investing a little portion of their equity in government bond ETFs. This is because the variance of the portfolio will be significantly lower at government bonds due to their negative correlation with stocks. A small dollar amount in Treasuries added to a stock portfolio won't alter expected returns significantly due to this effect of insurance against loss.
Unquestionably, the most serious indictment of the modern portfolio theory is that it evaluates portfolios by variance, not downside risk.
That is because modern portfolio theory treats two portfolios as exactly equivalent in desirability if they exhibit the same variance and returns. A portfolio may have that variance because it experiences frequent small losses. The other might be subject to that variance by virtue of rare but spectacular declines. Most investors would consider small losses to be better as they would be easier to endure.
Post-modern portfolio theory improves upon modern portfolio theory by considering downside risk rather than variance.
The efficient frontier is one of the most fundamental elements of modern portfolio theory. It is the line that indicates the combination of investments best for providing the maximum return for least risk.
The portfolio at the right-hand side of the efficient frontier bears more risk than what is predicted on its expected return. Lower level of return compared to risk can be found below the slope of the efficient frontier.
Although the theoretical foundation of MPT appears solid against real-world applications, that is what makes it so much more impressive. Investors employ MPT to create portfolios meeting investment objectives managed by price risks.
Investors use MPT to build portfolios that best strike the difficulty between risk and return. Selecting different combinations of assets having different risk-return profiles, they engineer possible portfolios which maximise expected returns for any given level of risk.
MPT allows one to allocate assets according to expected opportunities, standard deviations, and correlations between them. As MPT aims to create the most appropriate mixture in terms of risk tolerance and investment goals for the investor.
Investors take into account risk according to MPT as well as managing it in a way that minimises the volatility through diversification. The theory states that not all risks are at the system level, but by investing in a diversified portfolio, certain risks can be reduced or entirely eliminated.
Characteristics of MPT include tools to assess the performance of the portfolio. By comparing the risk-adjusted return of the particular portfolio with the efficient frontier, the investors can analyse the optimisation of that portfolio for the level of risk attached to it.
Modern Portfolio Theory is a very essential framework for modern investors who want to optimise their portfolios by balancing risk and return. The strong principles of diversification, efficient frontier, and risk-free assets give guidance for an informed decision-making to maximise returns while managing volatility risks. Despite the limitations of MPT as a whole, it remains a robust tool in portfolio management; giving a structured space for achieving success in investment. It is true that the dynamic nature of the market makes one empowered to best understand and learn how to apply MPT in specific investment strategies.
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