Few individuals confuse the term "portfolio" when discussing financial investments. A portfolio of investments is a diversified group of assets that generates income for the investor. In contrast, if you took a time machine back fifty years, no one would know what you were talking about. Incredibly, the concept of an investment portfolio didn't emerge until the late 1960s. We now find it impossible to picture life before investing portfolios, but this wasn't always the case.
History of Portfolio Theory
People still possessed "portfolios" in the 1930s, long before the development of portfolio theory. Their understanding of the portfolio and the primary strategy for constructing one differed vastly.
Most investors were looking for the best possible price on a solid stock. Regardless of the motivation, investing involves taking a risk on assets that you believe are currently undervalued.
As prices on the ticker tape didn't reflect everything at the time, information was still trickling in slowly. After the Great Depression, accounting restrictions helped tighten the market's loose ways, but the public still saw investing as a type of gambling best left to the affluent and pretentious.
Modern Portfolio Theory, Developed by Harry Markowitz
Harry Markowitz, an operations research graduate student at the time, supposedly needed a thesis subject. One of the stockbrokers he met in a waiting room inspired him to start writing about the market.
Because of this, in March of 1952, he published an essay titled "Portfolio Selection" in the Journal of Finance. 2 Instead of making headlines in the financial world, the work sat forgotten for a decade before being unearthed.
Only four of the book's fourteen pages included any text or debate, which may be why "Portfolio Selection" failed to elicit an immediate response. Graphs and random numbers dominated the remaining pages.
The Investor and Their Acceptance of Risk
Risk, rather than the lowest possible cost, was the takeaway from the essay for many readers. As a result, once an investor's risk tolerance was determined, filling in the formula with actual investments was a simple task. As with Newton's Philosophiae Naturalis Principia Mathematica, "Portfolio Selection" is generally viewed as something that someone else would have thought of in time but not as neatly.
Functioning of Contemporary Portfolio Theory
The investor's trade-off was codified in Markowitz's research. Stocks and other high-risk investments with potentially big rewards sit on one end of the investing teeter-totter. On the other hand, low-risk investments with poor returns can be found in debt issues like short-term T-bills. Investors that want maximum return with little risk tend to go toward the center.
Markowitz developed a formula for constructing a portfolio that optimally balances the investor's risk tolerance and desire for potential returns. He used the Greek letter beta to denote the portfolio's volatility relative to an S&P 500 index.
A portfolio that closely tracks the market has a low beta. Generally, the beta of a passive investment or "couch potato" portfolio is rather low. When a portfolio's beta is higher than 1, it demonstrates greater volatility than the market as a whole.
The Effect of MPT on the Financial Markets
With this notion in hand, investors are no longer at the mercy of their broker but may instead craft their portfolios based on their risk tolerance and desired returns. Bulls had the option to take more risk, while bears had the option to take less.
The need for such requirements led to the Capital Asset Pricing Model's prominence as a resource for constructing diversified investment portfolios. The Modern Portfolio Theory was developed from CAPM and beta, as well as other theories that were maturing at the time.
What Using MPT Can Do for You
The idea of modern portfolio theory has greatly altered the way investors think about risk, return, and portfolio management. The idea shows that spreading your money around might lessen your loss of exposure. In reality, its principles are widely followed by today's financial managers.
Since many passive investors want low-cost, diversified index funds, MPT is also implicit in this strategy. The effectiveness and popularity of passive investing are evidence of the widespread adoption of contemporary portfolio theory, which mitigates the impact of small losses in any stock and boosts overall returns.
The Verdict
Wall Street was hit by a tsunami of discussion on what MPT means for the market. Managers with a penchant for "gut trades" and "two-gun investment methods" were antagonistic against shareholders who sought to diminish their returns by reducing their exposure to risk.
The general public emerged victorious, led by institutional investors like pension funds. Even the most risk-taking investor now considers a portfolio's beta before making a move. And MPT opened the floodgates for indexing and passive investment on Wall Street.
