Assignment 8513 (Q NO.5)

Q. 5      

Explain Modern Portfolio Theory (MPT). Discuss types of risk highlighted by MPT with Example.                                                                              

Ans

Modern Portfolio Theory (MPT)

Modern Portfolio Theory (MPT), a hypothesis put forth by Harry Markowitz in his paper "Portfolio Selection," (published in 1952 by the Journal of Finance) is an investment theory based on the idea that risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. It is one of the most important and influential economic theories dealing with finance and investment.

Also called "portfolio theory" or "portfolio management theory," MPT suggests that it is possible to construct an "efficient frontier" of optimal portfolios, offering the maximum possible expected return for a given level of risk. It suggests that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification, particularly a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.

Consider that, for most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls "risk."

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn't rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio. 

In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's nest egg.

On the more technical side, there are five statistical risk measurements used in modern portfolio theory (MPT); alpha, beta, standard deviation, R-squared and the Sharpe ratio. All of these indicators are intended to help investors determine a potential investment's risk-reward profile.

MPT makes the assumption that investors are risk-averse, meaning they prefer a less risky portfolio to a riskier one for a given level of return. This implies than an investor will take on more risk only if he or she is expecting more reward.

The expected return of the portfolio is calculated as a weighted sum of the individual assets' returns. If a portfolio contained four equally-weighted assets with expected returns of 4, 6, 10 and 14%, the portfolio's expected return would be:

(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%

The portfolio's risk is a complicated function of the variances of each asset and the correlations of each pair of assets. To calculate the risk of a four-asset portfolio, an investor needs each of the four assets' variances and six correlation values, since there are six possible two-asset combinations with four assets. Because of the asset correlations, the total portfolio risk, or standard deviation, is lower than what would be calculated by a weighted sum.

Types of risk highlighted by MPT with Example

Modern Portfolio Theory focuses on the effect investments have on an entire portfolio, rather than as a single investment. In other words, choosing different types of investments will diversify your risk.

Markowitz wanted to prove that looking at investments as a whole portfolio rather than individual investments will provide greater returns in the end.

 Example

You invest in three stocks individually, not focusing on how they affect your entire portfolio. This means you are at the mercy of the stock market alone. If stocks in general drop, you could face serious risk without anything to offset that risk.

But if instead, you diversify without putting all of your eggs in one basket, you may offset your risk.

Let's say that instead of investing in just stocks, you put some money in bonds too. The bonds may offset the riskiness of the stocks. If stock prices drop, the bond prices may increase, helping to decrease the risk of a complete loss.

This is a simplified example. But it shows you how choosing a variety of investments from different asset classes can offset your risk.

Modern Portfolio Theory assumes that investors see risk and return as directly related we need to take a higher risk in order to receive higher returns.

The theory suggests, though, that diversifying will reduce the risk without reducing your returns. In other words, an investor should choose the portfolio with the lower risk without sacrificing the return.