Creating that balance is no easy task. In the 1950s, economist Harry Markowitz developed what’s known as “modern portfolio theory,” which uses a few basic principles to explain how investors might achieve the “ideal” portfolio.
While modern portfolio theory has some drawbacks, it is still utilized heavily to this day, particularly among financial advisors who invest in stocks and bonds on behalf of their clients. Markowitz went on to win a Nobel Prize for his work.
At Feldman Equities, we’ve had a lot of success in commercial real estate investing, so we have a lot of insight to share about today’s market. In today’s article, we look at the central tenets behind modern portfolio theory and to what extent these principles are still relevant today, nearly 70 years after the concept was first introduced.
What is Modern Portfolio Theory?
In the simplest form, modern portfolio theory argues that the risk and reward potential of any single investment should be evaluated not on a standalone basis, but rather in the context of an investor’s overall portfolio.
One of the tenets of modern portfolio theory is the idea of creating an asset allocation study. This study provides an estimated return for different asset classes, be it stocks, bonds, real estate and others. Economists then factor in an estimate for volatility, which is how modern portfolio theory measures risk. Risk is defined as how the portfolio differs from the average expected return of that asset class – in other words, the upward and downward deviations from the expected returns.
An asset class such as stocks, which can have large deviations from its expected return, is considered more volatile, and hence, riskier. Asset classes that are riskier will have a greater likelihood of suffering a loss, which is why a measure of volatility is needed for each asset type.
Modern portfolio theory then factors in correlation: how do different assets move together? Do they move in lockstep (perfectly correlated)? Perhaps some are more volatile, with one moving up a lot while the other moves in the opposite direction. Assets need to be weighed according to their connection to each other.
With these inputs, economists can then create optimization models to maximize a portfolio’s return on investment based on the investor’s risk tolerance.
Main Pillars of Modern Portfolio Theory
The notion of an ideal portfolio
When investors search for potential investment opportunities, most look for those that offer high returns without much risk. In an efficient market, the “ideal” investment probably does not exist, but the search for it has caused financial managers and investment analysts to spend time developing methods and strategies for doing so, many of which are based upon modern portfolio theory.
MPT argues that it is not enough to look at the expected risk and return of a particular stock, but rather posits that by investing in more than one stock (or asset class), the investor benefits from diversification, and thereby reduces the riskiness of the portfolio. By deploying this strategy, the investor can then create an optimized portfolio by investing in assets that balance the portfolio in relation to other investments.
Modern portfolio theory assumes that investors can create ideal portfolios by projecting an asset’s expected volatility, risk and returns in relationship (i.e. as correlated) to the portfolio’s other investments.
Diversified securities and asset classes
Modern portfolio theory urges investors to invest in diversified securities and other asset classes. Stocks, for example, are considered more volatile than bonds. To balance the portfolio, some combination of stocks and bonds should be included. Similarly, some stocks (e.g. small company stocks) are considered riskier than others. Stock investments should be balanced to provide greater diversification. The broader the range of securities and asset classes one invests in, the lower the risk the portfolio is exposed to.
Defining systemic and unsystematic risk
MPT holds that there are two components of risk associated with investment: systemic and unsystematic risk. Systemic risk, such as interest rates, recessions and war, are considered market risks that cannot be diversified away. Unsystematic risks, such as the risks associated with any given security or asset class, can be diversified away as one increases the number and type of assets in her portfolio.
Diversification can’t prevent systemic market risk, but it can minimize unsystematic risk
Unsystematic risk represents the component of an asset’s return that is not correlated with general market moves. For a well-diversified portfolio, risk or average deviation from the mean of each investment does not contribute much to portfolio risk. Instead, it is the difference in the individual assets’ levels of risk that determines the overall portfolio risk. Therefore, investors benefit from holding a diversified portfolio as opposed to individual assets. In other words, diversification can’t prevent systemic market risk—but it can minimize unsystematic risk.
What is the efficient frontier?
Modern portfolio theory relies on a concept called the “efficient frontier.” The efficient frontier is the optimal portfolio that offers the highest expected return for a defined level of risk, or conversely, the portfolios that offer the lowest risk in exchange for a certain expected rate of return.
The efficient frontier can be thought of like a line on an X- (risk) and Y- (return) axis. Portfolio alternatives can be plotted on this graph to show their risk relative to returns. A curved line represents the efficient frontier, or the portfolios considered “ideal.” Any portfolio plotted below that line is considered sub-optimal, meaning that the investor is not getting enough return for the portfolio’s level of risk. Based on an investor’s risk profile, they’ll want to choose a portfolio on or above the plotted line and then look at what comprises that portfolio. Ultimately, investors will want to choose a portfolio that is the appropriate target for their risk tolerance.
Modern Portfolio Theory: Still Modern?
High concentration in stocks and bonds markets
Investors that rely on modern portfolio theory are placing too high of an emphasis on publicly traded markets, such as those for stocks and bonds. Few investors consider the other asset classes that could add to and better diversify an investor’s portfolio – such as venture capital or commercial real estate. Today’s investors are instead looking to expand their horizons by adding alternative asset classes to their portfolios. Alternative asset classes behave differently in terms of their liquidity and volatility, which make them difficult to assess (i.e. correlate) using modern portfolio theory.
One reason investors are moving away from portfolios based on modern portfolio theory is that these portfolios tend to be more volatile, largely due to their over-investment in stocks and bonds (two asset classes that while different, are still correlated). During periods of economic uncertainty, for example, during the 2008 financial crisis, portfolios with a high concentration of stocks and bonds experienced tremendous volatility.
Compare this to investors who added commercial real estate to their portfolios: yes, these investors lost significant equity, but those with a long-term investment horizon benefitted from steady, ongoing cash flow that was not as tightly correlated with the securities markets.
Tendency to underperform
There is real concern that, with bond yields at historic lows, those whose portfolios are based on the modern portfolio theory will experience disappointing returns in the years to come. Given the close correlation between stocks and bonds, if both markets take a hit, portfolios that lack diversity into other asset classes will likely underperform.
Assumes stock performance can be an independent variable
Lastly, one drawback of modern portfolio theory is that it assumes that stock performance can be treated as an independent variable. It assumes that a stock price reflects the value of the stock because information about that company has already been priced in by the multitudes of investors who are in the market buying and selling on a daily basis. It assumes that all investors have the same information and therefore, that each stock is already “priced to perfection,” meaning that all of the expectations of that stock are already built into a discounted value to today. Yet stock performance cannot be evaluated in a vacuum as there are several external factors that can influence the value of a stock.
Related: Coronavirus Impact on Commercial Real Estate
Formulating a ‘Post’ Modern Portfolio Theory
A growing number of investors are looking to what’s being called “Modern Portfolio Theory 2.0,” which is essentially a refresh of the concept based on perceived flaws in the theory first advanced by Markowitz. Namely, investors are calling for portfolios to have more diversification, a reclassification of “risk,” and the inclusion of alternative asset classes in order to create truly balanced portfolios.
In order for a portfolio to truly be diversified, investors need to invest in more than just traditional securities such as stocks and bonds. This may include, for example, adding precious metals to a portfolio as these tend to have an inverse relationship to stocks and bonds. When the value of stocks and bonds declines, the value of gold, for example, tends to increase. Modern portfolio theory 2.0 calls for portfolios to be invested in a greater number of uncorrelated assets.
Rethinking risk as defined in MPT
There’s also been a push to redefine “risk” as conceived under modern portfolio theory. Traditionally, MPT requires investors to add “risky” assets to their portfolios (such as futures) for the sake of balancing the portfolio’s overall risk profile. Not all investors are open to doing so. Some investors are, frankly, more willing to invest in some asset classes than others.
This is at least one other inherent shortcoming in MPT. When running an analysis to determine which portfolios to plot on the efficient frontier, an investor can dictate that they do not want certain assets included—say, no more than 15% in small company stocks. The model is then re-run to plot portfolios on the efficient frontier based on those constraints. It’s similar to a nutritionist creating an “optimal” diet for a client, but only including the food groups the client is willing to eat in the amounts they’re willing to do so – it’s not so efficient, after all.
Today’s investors are looking to redefine risk to allow for greater flexibility based on their own personal investment preferences.
Considering other asset classes
Considering the points above, one way to increase diversity and redefine risk is by adding alternative asset classes to traditional investment portfolios. We’re already seeing this happen with commercial real estate. Institutional investors, for example, always considered CRE to be an alternative asset class.
Today, institutional investors are adding CRE to their portfolio at a remarkable pace. This is because commercial real estate has a relatively low correlation with the securities markets, which provides greater portfolio diversification.
Modern portfolio theory certainly has its critics, particularly among investors who are advocates of investing in alternative asset classes. That is not to say that modern portfolio theory should be disregarded altogether. Indeed, there are some principles that can be used as a general guide for investors which can then be coopted by those who want to create more balanced portfolios.
Of course, any investment should be made in the context of an investor’s overarching portfolio and investment goals. No investment is immune to macro-economic factors such as declines in economic activity. But there are indeed investments that can withstand short-term ebbs and flows in the market better than others.
Portfolios that include assets that are uncorrelated with each other will result in more stable portfolios over time. When in doubt, always consult with your investment advisor to discuss your options in full. Contact Feldman Equities today to find out how we can improve your investing portfolio and how we can reinvent your office building.
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