A variety of investment theories exist aimed at providing the greatest return for your money. Though some, at times, may prove successful, the success of these theories is never guaranteed. No theory can accurately predict the direction the stock market will move from one day to the next. However, some theories may help to minimize the risk of suffering great losses. One such theory is the Modern Portfolio Theory, which emphasizes having a diverse portfolio of securities. Here we will take a look at this theory attributes and how an investor can benefit from putting it into practice.
In Modern Portfolio Theory, statistical measurements derived from the past performance of an investment security are used to create assumptions about future performance. Using these statistical measurements, an investor will attempt to create a portfolio maximizing the return on investment while minimizing overall risk. To accomplish this feat, the Modern Portfolio Theory focuses on the importance of diversification. Diversification is the concept of balancing a portfolio with securities that have risk factors that do not correlate or have very little correlation between each other. This should hopefully cause an offset of gains and losses on individual securities. Diversification seeks to minimize the effects of each individual security’s unsystematic risk, or risk specific to one particular security. It does nothing to effect systematic risk, or risk that affects the market as a whole.
The standard deviation of a security defines its riskiness. It measures the difference between the riskiness of the security and the mean, or average, riskiness of the market. When combining several securities into a portfolio, a standard deviation for the entire portfolio is created. Hopefully, the standard deviation of the portfolio will be smaller than the deviation of the individual securities alone. This is the goal of diversification and the basis for the Modern Portfolio Theory. Using the standard deviation and a set of expected returns, an investor can plot these points along a graph called the efficient frontier. The efficient frontier will show the possible portfolios that can be created given a certain level of riskiness.
Using the Modern Portfolio Theory can be advantageous when looking to build an investment portfolio. However, usage of this theory alone will not guarantee success in the realm of investing. Keep abreast of current news that can have an adverse affect on your holdings. Thoroughly research to determine the right time to add or subtract securities from your portfolio, though this is subjective. Utilize the concepts of the Modern Portfolio Theory to help bolster your researching efforts. These tips will help you to invest wisely.