Harry Markowitz can be considered the first quant investor since he was the first to link risk and return in his seminary paper on Modern Portfolio Theory in 1952. Harry lived a good life till the age of 95. Sadly, he passed on recently, as reported below.
This post is dedicated to this industry titan. There will also be an extension to his original idea that forms the bedrock of what we do at AllQuant, so be sure to read till the end!
What is Modern Portfolio Theory?
Before Harry's seminary work, the investment world assumed that the best stock-market strategy was to choose the shares of a group of companies with the best prospects. However, this led to the "haphazard" creation of institutional portfolios that were volatile and vulnerable during recessions. Harry's revolutionary insight was that risk in any portfolio is less dependent on the riskiness of its components than on how they relate to one another. He then used advanced mathematics to calculate correlations and co-variances between the portfolio securities. This breakthrough insight has now permeated all aspects of money management, leading to the saying that diversification is the only free lunch in finance. If there is a simple diagram to illustrate the importance of Harry's insight, it would be the four quadrants below.
The diagram above is known as the opportunity space for investing. Any portfolio with a sufficiently long history would fit somewhere in one of the quadrants. It doesn't take a genius to want the portfolio to sit in the first quadrant because that gives the highest return with the lowest risk. However, most stock-heavy portfolios would find themselves in quadrant 2. Yes, stocks can deliver high returns but with high risk. It is even worse if the portfolio is in quadrant 4 because you do not get compensated for the high risk taken. This is possible if you end up with lousy stock picks.
Bond-heavy portfolios have the opposite problem. Bonds are less risky than stocks because they deliver regular coupons with a return of capital on maturity. However, the returns are low in comparison to stocks. Therefore, they sit in quadrant 3. The brilliant application of Modern Portfolio Theory is that you can create a portfolio that sits in quadrant 1 using a combination of stocks and bonds. There is no need to delve into the mathematics. Just know intuitively that the inverse relationship between stocks and bonds lowers the portfolio risk disproportionately more than the averaging effect on returns. We can create different portfolios with varying allocations to stocks and bonds and we arrive at the efficient frontier.
The magic of Modern Portfolio Theory is that we can find the right allocation between stocks and bonds such that the resulting portfolio will give us the best risk-adjusted return.
Beyond Modern Portfolio Theory
If we do not restrict ourselves to only stocks and bonds, we can extend the benefits of diversification and improve the efficiency of our portfolio. We can add other asset classes like commodities and FX. We can also create our own "asset classes" by using non-correlated investment strategies. The benefit of investment strategies is they can enhance the natural qualities of traditional asset classes. Below are just two examples.
Stock Plus Strategy
One of the strategies we teach is Trend-Following on stocks. This is a stock-focused strategy but it can deliver a better risk-adjusted performance than stocks as shown below.
With this strategy, we have created a "stock-plus" asset class that delivers higher returns than stocks with slightly lower risk.
Bond Plus Strategy
On the other end of the spectrum, we teach another strategy called Risk Parity. This strategy has exposure to stocks and bonds but tends to overweight bonds due to its nature. Compared to a pure bond portfolio, it delivers more bang for the buck.
This is a "bond-plus" asset class because it delivers higher returns than bonds with lower risk.
Pushing The Boundary
If we replace the 2-asset portfolio with our 2 strategies above, we can push out the efficient frontier to achieve a more efficient portfolio that sits deeper in quadrant 1 as shown below.
Conclusion
The Modern Portfolio Theory is not perfect. The primary criticism about it is that it uses historical data to build the efficient frontier and history is not a good indicator of the future. However, it gives us a very useful framework to build a robust investment portfolio as seen above. All this would not have been possible if not for Harry Markowitz. The man may be gone but his spirit shall live on in the work that we do.
Our next IBF accredited course is scheduled on 24-26 July. Enrol now to learn how to extend the Modern Portfolio Theory into a multi-strategy portfolio.
Or join us for our Free Financial Education Series over a cup of coffee!
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