In the financial world, a portfolio is the collection of investments held by an individual or an institution. In that sense, the history of Stock Portfolios goes back as far as stocks themselves do, as few investors are satisfied owning a single stock. Prior to the 1950s, most investors chose their second and third and fourth holdings, and above, by finding individual stocks with the highest reward potential and the lowest risk. The approach to building investment portfolios changed in 1952, when University of Chicago professor Harry Markowitz published a landmark paper entitled “Portfolio Selection.” Modern Portfolio Theory had arrived.

Modern Portfolio Theory

Modern Portfolio Theory (MPT) begins with the belief that it is not enough to build a portfolio of individual stocks with attractive reward potential at minimal risk. What is important is the combination of stocks and other asset classes, and their relationships to each other. The core principle is diversification. An investor with a high degree of knowledge in the oil and gas business might search high and low for the most attractive stocks in that sector. This is the classic example of putting all your investment “eggs into one basket”—oil and gas. MPT uses sophisticated probability calculations to design portfolios to match the best reward potential to an investor’s desired risk level. The calculations are complex, comparing historical average returns with standard deviations against the covariance of the coefficient, and on and on!

The important thing for investors to know is that the historical tracking of asset-class performance (not just stocks, but fixed-income investments like bonds as well) can identify correlations across classes. In short, when bonds go down, stocks go up—when stocks in Sector A are going down, Stocks in Sector B should be going up. The classic example would be Consumer Discretionary Stocks falling in harder economic times while Consumer Staples remain constant or begin to rise. Today, there is financial software available through financial advisors and on the Internet that can assess the diversification of your existing stock portfolio and recommend changes. While the principle of diversification inherent in Modern Portfolio Theory is still very much in vogue, the theory itself is not without controversy.

Modern Portfolio Theory uses complex mathematical calculations based on historical data to create investment portfolios that maximize returns while minimizing risk. The key is to diversify what you own into asset classes that behave differently from each other in different market conditions.

Limitations of Modern Portfolio Theory

In essence, MPT is a mathematical model that creates a diversified portfolio based on negative or low correlations across asset classes. A correlation of 1.0 means that the two assets move in the same direction. Correlations down to -1 indicate movement in the opposite direction. Consumer Discretionary stocks move in the opposite direction that Utilities move. Bonds and equities (stocks) move in opposite directions under certain market conditions.

For investors committed to stock portfolios only, placing portions of their available capital into bonds and other fixed-income asset classes goes against their personal investing philosophy. Jeremy Siegel, a professor at the Wharton School of Business in the U.S., demonstrated in his book Stocks for the Long Run that, over time, stocks outperform bonds.

In addition, critics point to the ability to manage the number of holdings that many MPT proponents advocate as minimally required, ranging from 15 to 20. Do you have the time to monitor 20 stocks properly?

Other critics claim that far more than 20 stocks would be needed to achieve the results that MPT is purported to deliver. Still others say that diligent adherence to transaction costs associated with such large portfolios cut into returns over time. Since the 2008 financial crisis, there have been many who point to the failure of the approach to protect investors. However, MPT does not claim to be able to manage systematic risk due to broad economic conditions like severe recessions. This kind of risk is said to be undiversifiable, and MPT proponents point out that portfolios constructed through this approach fared better in the aftermath of the crisis.

One limitation that gets little attention is the changing nature of stock markets. We live in a global world where events in the Ukraine affect stock prices across the board. Then there are the machines. Today it is estimated that 70% of the trades on the New York Stock Exchange on any given day are made by computer programs. In the aftermath of the U.S. Market Crash of 1987, investigators found that multiple quantitative computerized trading platforms had been designed to react in similar ways, thus contributing to the crash. The data on which Modern Portfolio Theory was based doesn’t reflect trading conditions of the past two decades.

Perhaps the most relevant criticisms of Modern Portfolio Theory are its reliance on three foundational assumptions—that all investors are risk-averse, that investors always act rationally, and that all investors have access to the same information at the same time. These assumptions have a direct bearing on all investors building their own stock portfolios.

Adhering to Modern Portfolio Theory means that some investors would be forced to put capital into asset classes that may be inconsistent with their investment outlook. The portfolio diversification does not provide complete protection against large-scale catastrophic events like the recent financial crisis. The data used to create the theory no longer reflects globalization and computerized trading.

Diversifying Your Portfolio

Despite its limitations, the concept of diversification inherent in Modern Portfolio Theory should be the cornerstone of any investment portfolio. When building a stock portfolio, the maxim that Rome wasn’t built in a day applies. But where do you begin?

Here are four critical issues to consider:

1. Investment Goals

2. Age and Investing Time Frame

3. Risk Appetite

4. Available Capital

Of the four, perhaps the most important is age. Younger investors have longer time frames for reaching investment goals. Your investment goal plays a role in the risk level you’re willing to assume.

Consider a 26-year-old person with an investment goal of appreciating enough capital to be able to retire in 15 years. Other 26-year-old investors might have investment goals of appreciating enough capital to build the homes of their dreams within five years.

While their respective portfolios will differ, both have the advantage of age and time frame, allowing them to recover in the event of market downturns. Blue chips and mature income-paying stocks should play minor roles in their portfolios, if any. Growth stocks and a few high-risk speculative stocks would form the cores of their portfolios. You can diversify across industrial sub-classifications as well as across asset classes and markets. That means, looking for attractive growth and speculative stocks in different businesses such as healthcare, biotechnology, energy, and technology.

Contrary to the assumption that all investors are risk averse, many younger investors with lofty investment goals have high-risk appetites. They seek risk in the belief that to achieve their desired rewards, one has to assume higher levels of risk.

Older investors have shorter time frames in which to achieve their goals, and therefore their portfolios will be more conservative, allocating most of their capital to blue chip, dividend-paying and defensive stocks.

In effect, if you build your own stock portfolio, you’re acting as your own financial advisor instead of paying to rely on the advice of someone else. Once built, what do you need to do to manage your portfolio?

When building your own stock portfolio, you need to consider your investment goals—your age and investing time frame, your appetite for risk, and your available capital. Younger investors can afford to take more risk than are older investors. Allocating a high percentage of available capital to growth stocks is appropriate, while older investors may look to blue chips and income stocks.

Portfolio Management

Some investors prefer a passive approach to Portfolio Management, checking progress perhaps once a quarter. They have read and accepted the advice to ignore daily market “noise,” and they refrain from getting caught up in the news-driven ebb and flow of stock prices.

That may be conventional wisdom, but an active approach to Portfolio Management has the advantage of identifying opportunities. Passive management in many ways relies on the assumptions that all investors behave rationally and have access to the same information at the same time.

First, if you really believe all investors have access to the same information at the same time, enter “insider trading” into your favorite search engine and read the results. Second, there is a newer field in market investing called behavioral finance that focuses on investor behavior. The “herd” mentality is one of their key observations. If you’re new to the market, it won’t take long before you see evidence of it. Before the opening bell, a news item appears that a promising biotech stock had a late-stage drug in trials and the U.S. FDA has rejected it. In pre-market trading, the herd awakens and the share price tumbles. The pace accelerates as analyst downgrades appear during the day. Markets have a way of “shooting first and asking questions later.” A review of what the FDA actually said was that they wanted more testing—so the potential, although delayed, is still there. Meanwhile, the stock price is crushed, and for those with high-risk appetites, a possible buying opportunity may be there for the taking. But you won’t see it if you’re not monitoring market news at least a few times a week.

The failsafe measure you have at your disposal is your written investment thesis. If a stock in your portfolio has made a dramatic movement upward or downward, research what it is that has happened to see if anything has changed in your fundamental reason for buying the stock.

Portfolio Management can be passive (checking your investments quarterly) or active (checking several times a week). Ignoring market noise is an advantage to passive management. Active management allows investors to spot buying opportunities. The investment thesis for purchasing a stock provides a safeguard against selling stock simply as a result of the “herd” abandoning it.

Bottom Line

Modern Portfolio Theory introduced the idea of diversification across asset classes into the process of building an investment portfolio. Using historical stock-performance data, MPT identifies asset classes and stock sectors that move in different directions, thus minimizing investor risk in a diversified portfolio. Investors interested in stocks only can build and manage their own portfolios, selecting stocks appropriate for their investment goals, age, investing time frames, appetites for risk, and available capital.

Summary:

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Modern Portfolio Theory uses complex mathematical calculations based on historical data to create investment portfolios that maximize returns while minimizing risk. The key is to diversify what you own into asset classes that behave differently from each other in different market conditions.

 

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Adhering to Modern Portfolio Theory means that some investors would be forced to put capital into asset classes that may be inconsistent with their investment outlook. The portfolio diversification does not provide complete protection against large-scale catastrophic events like the recent financial crisis. The data used to create the theory no longer reflects globalization and computerized trading.

 

P

When building your own stock portfolio, you need to consider your investment goals—your age and investing time frame, your appetite for risk, and your available capital. Younger investors can afford to take more risk than are older investors. Allocating a high percentage of available capital to growth stocks is appropriate, while older investors may look to blue chips and income stocks.

 

P

Portfolio Management can be passive (checking your investments quarterly) or active (checking several times a week). Ignoring market noise is an advantage to passive management. Active management allows investors to spot buying opportunities. The investment thesis for purchasing a stock provides a safeguard against selling stock simply as a result of the “herd” abandoning it.

 

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