Without a blueprint – you can’t create a house! Without a focal investment strategy most investors (and their financial advisors) make psychological, illogical, and frequently irrational investment decisions to their own financial detriment. In 1990 Harry M. Markowitz, a professor at Baruch College of the populous city School of New York, received a Nobel Prize in Economic Sciences.
His lifelong studies in the fields of investment risk, investment return, security relationship, and portfolio diversification will be the basis of what we realize today as “Modern Portfolio Theory”, or “MPT”. Modern Portfolio Theory is well-known in the investment community as a logical basis for sound portfolio management concepts. Modern Portfolio Theory should provide as a foundation for your investment planning “blueprint” as well. The crux of Modern Portfolio Theory (MPT) is the partnership between investment risk, return, and relationship.
Those factors are charted on what’s called the “efficient frontier” graph. The effective frontier graph illustrates securities expected coming back and the chance associated with achieving that expected investment return. On the left of the efficient frontier graph (the Y-axis) is the expected investment return plotted vertically. The horizontal footing (the X axis) is a dimension of the security’s expected risk (as illustrated by its standard deviation). The efficient frontier is a carefully upwards sloping arch stretching out, starting in the lower left corner and fading into the upper right part. That lightly sloping line signifies portfolio opportunities providing the utmost long-term expectation of profile return, with the least risk (volatility or standard deviation) possible.
A collection on the effective frontier collection is said to be “efficient” or “optimized” to garner the maximum financial benefit for every device of risk publicity. On a single graph as the effective frontier you could have multiple asset classes plotted in a seemingly random fashion. United States treasuries would be plotted with little return and little risk in the lower left part of the X & Y axis.
Asset classes such as rising market equities (shares) would be plotted in the much upper-right corner of the graph representing a higher level of risk with a higher potential investment come back. United States equities would fall someplace among them representing moderate risk and moderate investment return (in comparison with treasuries and rising market equities). Each asset class has a historical “correlation” to another asset class, meaning some investment securities perform differently at different periods in our economic cycle.
For example, in 2008 commodities like platinum and oil fluctuated wildly both along in value while USA collateral holdings floundered through the 3rd quarter, then sank dramatically in the fourth quarter as commodities stabilized. Treasury bond prices tended to trend upwards as interest rates came down. They are excellent examples of “non-correlation”.
Asset class investments performed good or bad in accordance with each other, and even though most asset classes finished up lower in value, there were varying levels of investment reduction. The effective frontier consists of stock portfolio solutions which statistically balance asset class correlations with their expected investment come back and risk. These collection solutions are completely varied and contain no securities or investment holdings with specific risk publicity.
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It is extremely hard to have a portfolio plotted ABOVE the efficient frontier, as it could have corresponding higher expected return and lower expected risk than what is possible given the available information. It really is however possible to have a portfolio plotted BELOW the effective frontier line – or what we should call an “inefficient portfolio”.
The most traders have “inefficient” portfolios, signifying they’re taking on more investment risk than their expected investment come back would require predicated on available information and targets for the future. Modern Portfolio Theory states how rational traders use diversification to improve their investment profile. MPT should theoretically provide a buyer with the best possible investment return for any given level of investment risk.
Are you invested such as a pro? Or an average Joe? The common Joe trader throws bits and pieces of different mutual money, stocks, exchange exchanged money, bonds, etc. into a portfolio, and phone calls it “diversified”. Chances are good, however, they’re actually not thoroughly diversified and haven’t removed all the specific risk in their stock portfolio. In addition, they could or might not have added enough non-correlative asset classes with their investment strategy to effectively decrease the systematic risk to the greatest extent possible. Modern Portfolio Theory has its faults however. The relationship, investment return, and risk are based off historical results and future expectations.