Modern Portfolio Theory and Portfolio Diversification
Introduced by Harry Markowitz in 1952, "Portfolio Theory" articulates the concept that assets in an investment portfolio should not be selected individually. Rather, it is of utmost importance to compare how the price of each asset in a portfolio set changes relative to how all other assets in the portfolio change in price. Markowitz was awarded the 1990 Nobel Prize in Economic Sciences for this work. It is an essential work supporting the concept of of asset-class diversification. Stocks, bonds, commodities, real-estate (and currencies) are discrete asset classes.
Risk / Reward of Asset Classes
It has been shown that over the past 100-plus years, stocks have averaged higher returns than bonds. However, when adjusted for risk, these returns have been nearly identical for both stocks and bonds. This is because bonds, while producing lower returns, also carry lower risk. Generally, all asset classes have the same risk/reward ratios over prolonged periods of time. Importantly, correlations across asset classes are generally low.
Investing is a tradeoff between risk and expected return. It has been shown that assets with higher expected returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. For any given expected return, MPT explains how to select a portfolio with the lowest possible risk. MPT dictates that an investor will take on increased risk only if compensated by higher expected returns. By extension, an investor who wants higher expected returns must accept more risk. By investing in more than one stock, an investor can reap the benefits of diversification - chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of this diversification.
Risk in the Marketplace
MPT holds that the risk for individual stocks or portfolio returns has two components:
NON-SYSTEMIC Risk - Also known as "specific risk", it is specific to an individual stock or portfolio and can be diversified away as you increase the number of stocks in your portfolio. Mathematically, this represents the component of a stock's return that is not correlated with general market moves.
SYSTEMIC Risk - These are market risks that cannot be diversified away and affect the markets as a whole. Recessions and wars are examples of systematic risk. This represents the component of a stock's return that is correlated with general market moves.
Models for Risk
MPT as a finance model does not always predict or quantify actual risk in the market well because the risk, return, and correlation measures used by MPT are based on merely expected values. Portfolios are vulnerable to the "achilles heel" of the model's design - fat-tailed, non-gaussian distributions of risk exemplified by precipitous and/or extended market declines. In both the Black–Scholes Options pricing model and MPT, there is no attempt to explain an underlying structure to price changes. Various outcomes are simply given probabilities. In contrast, structural models of risk ie: Probabilistic Risk Assessment ( PRA ) are used to formulate and evaluate critical questions in the fields such as engineering, business, or finance. The components of this method and their relationships are elaborated in Monte Carlo Simulations. You can learn more about constructing and using this model here Office.Microsoft.com. However it is critical to note that merely possessing the ability to properly or continuously assess risk in the marketplace does not necessarily produce acceptable investment returns.
Determinants of Under-Performance
Active Portfolio Management
Passive Portfolio Management
Excessive Non-Systemic Risk / Under-Diversification
Excessive Systemic Risk / High Beta
Improper Utilization of Valid Financial Models>
Excessive Transaction Costs
Address each of these factors to develop a simpler, more effective, and easier way to invest in the markets:
Super Index with ALPHA SYNTHESIS
In contrast, a recent study by the Dow Jones company reported that of 715 top-performing funds and advisers for the past 4 years through March, 2014, only 2 of these 715 stayed in the top 25% through this 4 year period.** It is simply a well-established fact that the vast majority of MONEY MANAGERS and PROFESSIONAL PORTFOLIOS fail to beat the INDEX FUNDS/market averages. The SuperIndex ®️ has been shown to significantly out-perform both these same managers and INDEX FUNDS/market averages.
This includes all Major Asset Classes**
1. Equities and Large, Mid, Small Cap Indexes(DOW30, S&P500, RUSSELL2000, NASDAQ100).
2. Precious Metals(GOLD SILVER PRECIOUS METALS INDEX, and COMMODITY INDEX).
3. Varieties of Bonds (US TREASURIES, CORPORATE BONDS, and HIGH YIELD BONDS).
4. Real Estate Funds, REIT's and ETF's.
* All Data courtesy www.timertrac.com
** Wall Street Journal - Investing in Funds & ETFs. Sept 8, 2014