A dear friend of mine by the name of Samukelo Nkosi once introduced me to Harry Markowitz, an economist, and his famous work of Modern Portfolio Theory (MPT). Initially, I thought MPT was just a tiny theory in finance, but after hearing it from not only Samukelo but other investors and finance professionals as well, I discovered that the concept had an entire academic literature talking about it. I would later also discover that this work by Mr Markowitz, which was published in 1952 in the Journal of Finance, ultimately won him the Nobel Prize in Economics. This achievement for me was truly remarkable and shows the significance of Mr Markowitz’s work.
What is Modern Portfolio Theory?
The technical definition of Modern Portfolio Theory tells us that it is a mathematical framework for putting together an investment portfolio (portfolio definition: a collection of assets) such that the expected return is maximised for a given level of risk. In simpler terms, it is an academic theory and investing practice that helps people to choose stocks and other assets that would be the most beneficial to their collection of investments, or “portfolio”.
As a theory, MPT makes the argument that the risk of an asset or single investment should not be viewed alone, but rather should be viewed by how the investment will affect the portfolio’s overall risk and return. In simpler terms, a single investment’s return is less important than how the investment behaves in the context of the entire portfolio. So as san individual, before making an investment, you should always look at the bigger picture of the effect of the investment being made.
The thing I find to be very interesting about MPT is that the concept sounds similar to that of diversification (diversification definition: the idea that owning different kinds of financial assets in different sectors or industries is much less risky that owning only one type of financial asset in a single sector or industry). So in a sense, if you know about the concept of diversification, you already know a great deal about MPT.
Another important and interesting aspect of MPT is that it assumes that, as an investor applying the theory to your investments, you are risk-averse. That is, you try to avoid taking on more risk in your investment portfolio and only take on more risk when it is absolutely necessary to do so.
Modern Portfolio Theory in action
So, being new to investing, you’ve officially signed up with a stockbroker or Financial Services Provider and have an investment account. This is of course after having submitted all of your documentation in line with FICA. You now move on to depositing money into your investment account and are now ready to invest. But then, one of the question you ask yourself at this departure point is: “How will I create a stable investment portfolio, with the right mix of financial instruments, that gives me a good return on my investment?” Well, fortunately for you, the answer to this important question lies in MPT.
Let’s look at a scenario of how MPT can help you construct your stable portfolio: You have shares in Company A, assuming this was your first investment, which is an oil company. You are considering expanding your portfolio, and your final choices are between Company B and Company C. Company B is also an oil company, and Company C is a major retailor. If everything else is the same about both company B and C, like the investment returns you are expecting from both Company B and C over the same time period, and their share prices are also relatively similar, then Modern Portfolio Theory would suggest that you buy Company C instead of Company B. In this way, you have in made the better, more stable choice in investment for your portfolio.
The MPT logic behind this is that you should try to buy companies that are not affected by the same economic conditions. If you held shares in both Company A and Company B in your portfolio, and they are both oil companies, then when the price of oil goes down for any number of reasons, then your whole portfolio would lose you money because both Company A and Company B have a declining share price happening at the same time. Alternatively, if you held shares in Company A and Company C in your portfolio, it could be the case that when the price of oil goes down, the retail industry won’t be affected by this. As a result, only Company A would have a declining share price and lose you money whilst your retail investment in Company C does not. In this case, your portfolio could be protected overall by Company C’s share price going up.
In official financial terminology, it is said that Company A and Company B are “positively correlated” because they can be affected by similar economic conditions, the change in the price of oil for example, in their industry. Company A and Company C are said to be “uncorrelated” or “negatively correlated” because economic conditions that affect one company won’t necessarily affect the other company. This concept of correlation doesn’t only apply to shares. When buying commodities, cryptocurrencies, cows, and other kinds of assets, you should take their correlation into consideration.
Modern Portfolio Theory states that a strong and resilient portfolio can be constructed by buying uncorrelated assets, and I totally agree with this logic. I do hope you are able to find a place for MPT in your investment journey, and all the best with constructing your portfolio.
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