Introduction

One of the tenets of Modern Portfolio Theory is that you shouldn’t assess the risk of an asset in isolation. Instead, you should examine an asset’s risk in the context of how adding that asset to a portfolio impacts the risk of the total portfolio. More specifically, some risky assets can have a negative correlation with stocks and bonds and, thereby, offset their underperformance.

Portfolio Efficiency

More advanced investors can optimize their portfolio, seeking the “most efficient” portfolio for their particular risk tolerance. “Most efficient”, means:

• no other feasible portfolio with equal risk has greater expected returns, and
• no other feasible portfolio with less risk has equal returns.

If it were otherwise, then you would select either the portfolio with greater returns or the portfolio with equal risk or equal returns and lesser risk.

Academics call this the “efficient frontier”,  using modern portfolio theory. There are two major models: mean variance analysis and Black–Litterman.

Mean Variance Analysis

Mean variance analysis was developed by Nobel laureates James Tobin and Harry Markowitz. Risk and return profiles of different asset allocations are tested using statistical techniques that combine expected returns, variances, and covariances.

MVO is a widely accepted framework for managing a diversified investment portfolio. MVO can also be used to determine how many assets to include in your portfolio. To calculate the MVO, you need to know each asset class’s standard deviation, correlation, and expected return.

If you could divide your portfolio among uncorrelated assets, then you would increase your return while decreasing your risk.

Summary

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Updated on October 18th, 2019