The Modern Portfolio Theory is a mathematical formula for investment analysis that was developed in the 1950s. The methodology is designed to calculate how to maximize a portfolio’s return within a specified level of risk – or in thinking from the other direction, to minimize a portfolio’s risk within a specified level of return. Most people interpret this to simply mean you should diversify a portfolio and it will be less risky in the long run. However, in delving deeper into the math behind this we find there are two important factors modern portfolio theory is suggesting about diversification.
The first part of modern portfolio theory is works to address Specific Risk which is associated with a single security. For our example, if we use a single stock as an investment then we are relying, as the name suggests, on that specific stock. If this one company does well we in turn can make a profit, but as history is our guide, thousands of companies have come and gone so modern portfolio theory suggests we invest in a number of different stocks. For our analogy we will use the Irish Potato Famine of the 1840’s. This was a time in history where approximately 30% of Ireland was dependent on potato for the bulk of their caloric needs. When the potato fungus struck approximately 1 million people in Ireland died because their main food source was being destroyed. By contrast the people of Peru also farm the potato where it is too is a main food source. However, they have access to 5,000 different types of potato and the typical farm field will have approximately 300 of these cultivars. When the potato blight reached Peru only a few species of potato were affected and so their main source of food was affected very little. This risk mitigation technique is referred generally as diversification.
The second risk is called Systematic Risk which describes the risk of an industry or sector. So, in this example we are going to have an investor purchase 100 stocks of different technology companies. By definition our investor would be diversified, but they would be relying on only one industry and as we saw in the year 2000 this would have been disastrous as the stock market bubble burst on this sector. Having a portfolio that was constructed from a number of sectors would have fared much better. If we again use food within our analogy we can go back to the people of Peru where their practice of growing many different types of potato has protected them from the blight which typically only affects a few strains of potato. However, because potato is their main food source and they have limited access to other types of crops, there is a malnutrition crisis among children of this region. They have many potatoes to eat, but without a varied diet, major health issues remain. This second form of risk mitigation is referred generally as asset allocation.
Modern Portfolio theory and its accompanying techniques have retained their position as a stalwart of portfolio construction for nearly 50 years. Prior to implementing any financial strategy, individuals should consider their investment objective, time horizon, and tolerance for risk. Investors should also consider the fees and charges associated with implementation of any investment plan. No investment strategy can guarantee a profit or assure favorable results.