Barbados’ Jeffrey Lipton: What Modern Portfolio Theory Means

The stock market is a strange beast. Known to create and destroy fortunes in the blink of an eye, this constant volatility often makes the stock market feel like an unpredictable ocean ebbing and flowing at will. Famed American author and publisher William Feather once said, “One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.”

The stock market is a strange beast and calls for constant vetting and monitoring.

As Feather’s quip points out, every investor feels as if they are making the right decision and on the right track to investment success. However, not all investors do well in the market. Why?

Well, there is no one conclusive answer, but poor stock market performance may be attributed to poor judgement or lack of a sound investment plan.

To put it bluntly, creating an investment plan is an arduous task that needs to be vetted and monitored in order to assure that it’s working.

“Planning is the most important part of the investing process, yet most investors spend the least amount of time on it (if any time at all),” notes the Parsimony Investment Research organization. “Clearly, planning is not as much fun as buying a stock…but it is 10 times more important!”

Creating an investment plan is only the first step in creating an investment portfolio that mirrors your goals. This is where an investment strategy comes into play. One of the most popular investment strategies is something called Modern Portfolio Theory (MPT), a theory that hinges on portfolio diversification.

Introduced in the 1952 Journal of Finance by Harry Markowitz, MPT hinges on the premise that diverse investments are more lucrative and promising than investing in one area. By investing in more than one stock, an investor can reap the benefits of diversification while simultaneously reducing their risk.

You may be asking, “Well, Jeffrey Lipton, how does a 64 year old theory still apply today?”

Because MPT quantifies the benefits of diversification, it remains as sound of a theory today as it was when Markowitz first published it. MPT’s focus on the portfolio as a whole allows for maximum results because the return from a single asset is less important than how that asset’s value moves against overall portfolio value. By looking at the statistical relationship between all the assets in a portfolio on a risk and return basis, the investor can optimize returns against a chosen level of acceptable risk.

As NASDAQ’s Trevir Nath pointed out last year, one core principle of MPT emphasizes that greater potential returns are associated with higher risk and conversely, the lower the risk, the lower the return. “Over a period of time the theory suggests there is no portfolio greater than the market portfolio,” wrote Nath. “As a result, the optimal portfolio will provide neither the greatest returns nor the lowest risk, but a balance residing on the Efficient Frontier.”

MPT is not without its own unique risk sets. MPT often requires investors to re-think notions of risk and can even demand that the investor take on a perceived risky investment in order to reduce overall risk. This can be a hard sell for an investor who is unfamiliar with the benefits of sophisticated portfolio management techniques.