Modern Portfolio Theory, or MPT, is a framework for investing. It provides part of the intellectual underpinning of our firm’s approach to managing investments. So, it is important to explain it periodically.
Just as constructing the framework for a home is strategically designed by connecting one piece of wood with another, MPT provides a system for constructing a portfolio based on measurable dimensions of investments – history and quantitative characteristics.
Owning different kinds of investments is less risky than owning only one type of asset, and MPT is a system for diversifying across a wide range of assets based on their statistical characteristics.
Classifying investments based on their distinct characteristics -- such as the aggregate value of a company’s shares outstanding, profit growth, and share-price variance -- imposes a quantitative discipline for selecting combinations of investments based on historical data. Investments revolve around a world that is always changing, however, and not enough statistical history of different kinds of investments exists to make investment predictions about the future with certainty. MPT is a way of managing that uncertainty.
Just as every stud and joist in a home has its own mathematical dimensions, investments have their own unique shape and characteristics. MPT organizes statistics that measure the characteristics of different kinds of investments used to construct a portfolio. It’s a way of building a portfolio so that the return you expect over the long run is maximized for a given level of risk.
Just as a home can be built to your personal needs and preferences, so, too, can a portfolio be custom-built to suit your personal risk tolerance specifications. To be clear, cookie cutter portfolios is not what we do. Each portfolio can be tailored to an investor’s preferences.
Economist Harry Markowitz introduced MPT in a 1952 essay. He was awarded a Nobel Memorial Prize in Economic Sciences in 1990. Thus, it took from 1952 to 1990 -- 38 years -- for Markowitz to be recognized by the Nobel committee. This provides insight into the how long it takes for knowledge to be accepted.
Over the last 70 years, the power of Modern Portfolio Theory has grown to be understood. It is now the framework for investing embraced by most institutional investors worldwide and it is now a foundational element in teaching finance at the world’s best colleges and universities.
MPT is a starting point for constructing a quantitatively driven portfolio based on fundamental economics. Just as the laws of physics are relied upon for building a home, fundamental factors of economics are relied upon in constructing a portfolio using MPT. To receive a report on investment performance and current financial economic conditions, please contact us.