Practice and Theory in Modern Portfolio Theory

Modern Portfolio Theory was developed in the 1950’s with the belief that portfolio returns could be maximized for a given amount of investment risk by combining assets in a particular manner.

The theory is that, using relationships between risk and return such as alpha and beta, and defining risk as the standard deviation of return, an “efficient frontier” for investing can be identified and exploited for maximum gain at a given amount of risk.

Much of Modern Portfolio Theory is now questioned. So why should you care? Why learn about something that is not 100% accepted as fact? The reason you should care is the principles and theories are foundations for building sound portfolio management strategies.

There is no “perfect” model. Those who believe they have perfect models find out that markets change, correlations change, people change, business changes; you get the idea.

Practice and Theory in Modern Portfolio Theory

What have we learned from Modern Portfolio Theory?

Proper asset allocation works by reducing portfolio volatility and/or increasing long term returns when non-correlated asset categories are combined.

Proper investment diversification of individual investment choices reduce volatility risk by nearly eliminating specific or unsystematic risk.

Standard deviation provides a credible model for understanding the probability of outcomes far away from the mean (average).

Modern Portfolio Theory concepts such as Alpha and Beta, Standard Deviation, the Sharpe ratio, Capital Asset Pricing Model (CAPM), Regression, and R-squared have provided a foundation for debate that has continued to provide additional insight into the relationship between investment risk and returns.

How to Use Investment Portfolio Theory

One of the first lessons that should be learned from Modern Portfolio Theory is to not have too much faith in any model. Nothing is a sure bet; that is why it is called investment risk!