Introduction to Modern Portfolio Theory

 


What is Portfolio?

A portfolio is a collection of financial investments such as stocks, bonds, commodities, cash and cash equivalents, including closed-end funds and exchange-traded funds (ETFs). Stocks, bonds and cash are generally considered to be the core of a portfolio. This is common, but doesn't have to be the norm. A portfolio can include a variety of assets, such as real estate, art, and personal investments.

  • In the 1950s, Harry Markowitz, considered the father of Modern Portfolio Theory (MPT), developed the basic portfolio principles that underlie modern portfolio theory.
  • His original contribution was published in 1952, making portfolio theory about 60 years old. Over time, these principles have been adopted by the financial community in a variety of ways, with the result that his legacy of MPT is very broad today.

Primary Impact of MPT:

  1. The primary impact of MPT is on portfolio management, because it provides a frame-work to systematically select portfolios according to return and risk principles.
  2. Financial advisors use the principles of MPT in advising their individual investor clients.
  3. Many financial commentators use MPT terms in discussing the current investing environment.

Answer a basic question:

Is the risk of a portfolio equal to the sum of the risks of the individual securities comprising it?

The answer is NO! Markowitz was the first to show that we must account for the interrelationship among security returns in order to Calculate portfolio risk and  reduce portfolio risk to a minimum level for a given return level.

Types of Portfolio:

There are as many  types of portfolios and portfolio strategies as there are investors and money managers. You can also  choose to have multiple portfolios. Its content may reflect  different strategies and investment scenarios and may be structured for  different needs.

A Portfolio Investment

When using a portfolio for investment purposes, you expect stocks, bonds, or other financial assets to generate returns, appreciate in value, or both over time. Portfolio investments can be strategic. That is, when a financial asset is purchased with the intention of holding the asset for the long term. or tactical – when you  buy and sell assets aggressively in hopes of making short-term gains.

A Hybrid Portfolio

A hybrid portfolio approach diversifies across asset classes. To build a hybrid portfolio, you need to take positions in fixed income, commodities, real estate, and even the arts, not just stocks. Hybrid portfolios typically consist of relatively fixed proportions of stocks, bonds, and alternative investments. This is beneficial because equities, bonds, and alternatives historically have not shown a perfect correlation with each other.

A Defensive, Equities-Focused Portfolio

Defensive portfolios tend to focus on recession-proof consumer goods. Defensive stocks perform well in both bad and good times. No matter how bad the economy is, companies that make products that are essential to our daily lives will survive.

An Aggressive, Equities-Focused Portfolio

Underlying assets in  aggressive portfolios typically take on greater risk in search of higher returns. Active investors look for companies that are in the early stages of  growth and have a unique value proposition. Most of them are not yet common household names.

A Speculative, Equities-Focused Portfolio

Speculative portfolios are best suited for investors with a high risk tolerance. Speculative play may include initial public offerings (IPOs) and shares rumored to be acquired. Technology or healthcare companies developing a single breakthrough product also  fall into this category.

An Income-Focused, Equities Portfolio

This type of portfolio benefits stakeholders from dividend-paying stocks or other types of distributions. Some  stocks in the Income Portfolio also apply to the Defensive Portfolio, but  are selected here primarily for their high yields. The income portfolio should generate positive cash flows. A real estate investment trust (REIT) is an example of an investment that generates income.