Response
to your frequently asked questions...
What is
this talk about Modern Portfolio Theory?
Modern portfolio theory (MPT) was introduced by Harry
Markowitz with his paper "Portfolio Selection" which
appeared in the 1952 Journal of Finance. Thirty-eight years
later, he shared a Nobel Prize with Merton Miller and
William Sharpe for what has become a broad theory for
portfolio selection.
Portfolio theory explores how risk averse investors
construct portfolios in order to optimize expected returns
for a given level of market risk . The theory quantifies
the benefits of diversification. Out of a universe of risky
assets, an "efficient frontier" of optimal portfolios can
be constructed. Each portfolio on the efficient frontier
offers the maximum possible expected return for a given
level of risk. Investors should hold one of the optimal
portfolios on the efficient frontier and adjust their total
market risk by leveraging or deleveraging that portfolio
with positions in the risk-free asset.
Based upon strong simplifying assumptions, a capital asset
pricing model concludes that the market portfolio sits on
the efficient frontier, and all investors should hold that
portfolio, leveraged or deleveraged with positions in the
risk-free asset.
Portfolio theory provides a broad context for understanding
the interactions of systematic risk and reward. It has
profoundly shaped how institutional portfolios are managed,
and motivated the use of passive investment management
techniques.
The mathematics of portfolio theory is used extensively in
financial risk management and was a theoretical precursor
for today's value-at-risk measures. (www.riskglossary.com)
NOTE:
Translating Modern Portfolio Theory into investment
strategies requires strong simplifying assumptions -- each
of these three words are important. We are all accustomed
to assumptions, and naturally they are commonly
simplifying. The STRONG aspect makes the importance of the
assumptions much greater.
Many of the "wire houses" are promoting their computer
models to pick an "optimum" portfolio. It is not that
simple, period.
