Modern Portfolio Theory developed by Nobel Economist Harry Markowitz in 1952 was founded on the observation that investors did not hold just one investment but created a portfolio made up of a number of individual investments it is essentially a way of reducing risk by diversifying and holding a portfolio of investments (Shipway, 2009). It represents one of the most important and influential economic theories dealing with finance and investment.

The explanation behind the theory of spreading investments across a range of assets is that in a portfolio, unexpected bad news regarding one company might compensated, to some degree,  by unexpected good news in a different company. In other words the theory suggests that investment is about choosing the right combination of different stocks. It is the same intuition that makes players of the national lottery buy more than one ticket, having more tickets spread the risk involved. The theory made two assumptions, that investors are rational and want to get a return equal to the amount of risk, and that all investors are risk averse.

According to modern portfolio theory, risk come in two major categories:

Systematic risk, also called undiversifiable risk or market risk

Unsystematic risk, also called specific risk, diversifiable risk or idiosyncratic risk

Systematic risk is the possibility that the entire market and economy will be affected, so it cannot be avoided by diversifying.. Sources of systematic risk could be macroeconomic factors such as inflation, changes in interest rates, fluctuations in currencies, recessions, wars, etc. Factors which influence the direction and volatility of the entire market would be systematic risk. An individual company cannot control systematic risk.

Unsystematic risk is company or industry specific. This type of risk is not correlated to systematic risk and can be diversified away as you increase the number of stocks in your portfolio.

The above diagram shows that the more you diversify the less unsystematic risk you are likely to encounter.

In order to compare investment options, Markowitz developed a system to describe each investment or each asset class, called the efficient frontier. This describes the relationship between the return that can be expected from a portfolio and the riskiness of the portfolio. The purpose of The Efficient Frontier is to maximize returns while minimizing volatility. The concept of an efficient frontier can be used to illustrate the benefits of diversification. An undiversified portfolio can be moved closer to the efficient frontier by diversifying it. Diversification can, therefore, increase returns without increasing risk, or reduce risk without reducing expected returns.

The graph above shows an efficient frontier. The line represents the efficient frontier which is the optimal combination of risk and return. Each dot represents individual portfolios; the dots which are closer to the efficient frontier line are the investments that are expected to show the best performance with smallest risk.  The dot circled in red, for example, could be a poor investment as it is very high risk and the expected returns are not that favourable.  The dot circled in blue would be an ideal investment for someone who is risk-averse as it is gives the best return for the amount of risk involved. However investors who don’t mind taking risks might opt for the one circled in orange as this is very high risk but the expected return is also very high.

Modern Portfolio Theory is subject to a number of limitations and imperfect assumptions. It should only be used as a guide as the theory does calculations based on expected values to measure the correlations between risk and return in the future. Many experienced investors consider past performance not to be a guarantee of future performance.

References

Markowitz, H. (1952) Portfolio Selection. The Journal of Finance (Vol .17, pp.77-91) http://www.jstor.org/discover/10.2307/2975974?sid=21105588368133&uid=4&uid=3738032&uid=

Shipway, I. (2009) Trusts & Trustees. The oxford Journal. (Vol. 15, pp.66-71) http://tandt.oxfordjournals.org/content/15/2/66