Modern Portfolio Theory

A sophisticated investment approach developed by University of Chicago economist Harry Markowitz, who won a Nobel Prize in 1990, also called ""portfolio management theory"" or simply ""portfolio theory."" According to ""Wealth Enhancement & Preservation,"" ""Portfolio theory allows investors to estimate both the expected risks and returns, as measured statistically, for their investment portfolios. In his article 'Portfolio Selection' (in the Journal of Finance, in March 1952), Markowitz described how to combine assets into efficiently diversified portfolios. He demonstrated that investors failed to account correctly for the variance among security returns. It was his position that a portfolio's risk could be reduced and the expected rate of return could be improved if investments having dissimilar price movements were combined.

For example, some companies' stock tends to follow in step with overall economic trends. These are referred to as cyclical stocks. Other companies tend to do well when the economy does poorly, and these are known as counter-cyclicals.

Holding securities that tend to move in concert with each other does not lower your risk. 'Diversification reduces risk only when assets are combined whose prices move inversely, or at different times, in relation to each other.' ""

In other words, Markowitz explained how to best assemble a diversified portfolio, and proved that such a portfolio would likely do well. Markowitz also proved that, all things being equal, the portfolio with the least amount of volatility would do better than one with a greater amount of volatility.

 

 

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