Modern Portfolio Theory (MPT)

Modern Portfolio Theory (MTP), sometimes referred to as “mean variance analysis”, was first pioneered by American economist Harry Markowitz in his paper “Portfolio Selection” which was first published in 1952. The work was later awarded a Nobel prize and despite its age, MPT continues to be utilisted extensively in modern portfolio construction and analysis.

Key tenets of MPT are the measurement of risk and correlation. MPT provides a framework to construct a portfolio with a maximal return for a target level of risk, or the inverse- a minimal level of risk for a target level of return.

Modern Portfolio Theory, to borrow from Aristotle, explains that ‘the whole is greater than the sum of its parts’ when it comes to engineering the risk of a portfolio. The theory posits something that would otherwise seem counterintuitive – that an investor can produce better risk-adjusted returns in a low-risk portfolio by adding risky investments. In a portfolio, assets that have low or negative correlation to one another, can be combined to produce superior risk/reward profiles.

To give a crude example, if investment A has annualised risk of 2%, and investment B has annualised risk of 2% you might assume that a portfolio allocated 50% to investment A and 50% to investment B would have a total annualised risk of 4%. Although this could be the case, if investment A and B have negative, or zero correlation, the resulting risk of the portfolio could actually be less than 2%.

This is the fundamental case for diversification in investment portfolios.

Because of concerns surrounding rampant inflation, Mr. Client asks his adviser for suggestions on a way to invest his excess cash deposits for the short to medium term without extreme volatility. His adviser suggests investing in a portfolio of short duration treasury notes. The short duration will serve to reduce the interest rate sensitivity of the portfolio whilst providing Mr. Client with a small yield. Acting on a hunch that the portfolio can be better optimized, his adviser runs a mean-variance optimization model.  The results show that allocating 10% of the treasuries portfolio to a currency-hedged small cap European equity fund would actually reduce the volatility of the portfolio and increase the expected return- expressed as a higher Sortino ratio than the original 100% treasury note portfolio.