A NEW WALKING

SHOE:
MODERN
PORTFOLIO
THEORY
 01

Introduction
Introduction
• Traditional Valuation Theories:
• "Firm-foundation" and "castle-in-the-air" theories criticized by academics.
• Cannot guarantee high returns.
• The Rise of MPT:
• Developed by academics seeking a new strategy.
• Offers a framework for smart portfolio construction.
• MPT's Core Insight:
• Reduce Risk: Diversification is key. Invest in a variety of assets to mitigate
risk from any single holding.
• Potentially Higher Returns: By choosing the right mix of assets, you can
increase overall return while managing risk.
 The Role Of Risk

Efficient Market Theory Focus on Risk, Not

(EMH) Criticism of EMH Prediction
• Profitable Investors Academics often
• Explains the Random Exist: acknowledge this,
Walk concept. Some stocks but...
• Markets quickly adjust outperform others,
to new information, suggesting skill can ...argue superior
making future price play a role. returns come from
prediction difficult. "Common sense" taking on greater risk.
• Everyone (professionals, suggests some
amateurs) has an equal investors beat the
chance of success. market.
DEFINING RISK: THE DISPERSION OF
RETURNS
• Risk: A Slippery Concept: Defining risk in investments is challenging.

• Focus on Return Volatility:

• Investment risk is the chance your expected returns won't be met.
• Key metric: Dispersion of Future Returns (how much returns might deviate from the
expected average).
• Lower dispersion = Lower risk (returns likely stay close to average).
• Higher dispersion = Higher risk (returns could fluctuate significantly).

• Example:
• Safe investments (e.g., 1-year Treasury bills) offer low dispersion (predictable returns).
• Stocks (e.g., local utility) have higher dispersion (returns can vary more, potentially leading
to losses).
 02
Illustration and
DOCUMENTING
RISK
Expected Return and Variance Measures of Reward and Risk

Investors seek to balance reward (return) with risk.

Expected return (ER) is the average return you expect from an investment, considering different
possibilities. (Formula: ER = Σ(Return * Probability))

Risk refers to the uncertainty of future returns, measured by the dispersion around the expected
return.
• Consider an investment with 3 possible outcomes: Normal economy (33% chance, 10%
return)
• Rapid growth (33% chance, 30% return)
• Recession (33% chance, -10% return)

Expected return = 1/3(0.30) + 1/3(0.10) + 1/3(–0.10) = 0.10.

Variance = 1/3(0.30–0.10)2+ 1/3(0.10–0.10)2+ 1/3(–0.10–

0.10)2
Standard deviation equals
0.1634.

• The greater the dispersion or variance, the greater the possibilities for disappointment.
• Although the pattern of historical returns from individual securities has not usually been
symmetric, the returns from well-diversified portfolios of stocks are at least roughly
symmetrical.

• Two-thirds of the monthly returns tend to

fall within one standard deviation of the
average return and 95 percent of the
returns fall within two standard deviations.
DOCUMENTING RISK: A LONGRUN
STUDY
One of the best-documented propositions in the field of finance is that, on average, investors
have received higher rates of return for bearing greater risk.

The most thorough study has been done by Ibbotson Associates.

Their data cover the period 1926 through 2009

What Ibbotson Associates did was to take several different investment vehicles—stocks, bonds,
and Treasury bills—and measure the percentage increase or decrease each year for each item.

Thus, stocks have tended to provide positive “real” rates of return, that is, returns after
washing out the effects of inflation.

However, that common-stock returns are highly variable

Source: Ibbotson Associates.
 03
MODERN
PORTFOLIO
THEORY (MPT)


The theory was invented in the 1950s by Harry Markowitz, and for his contribution
he was awarded the Nobel Prize in Economics in 1990

The theory tells investors how to combine stocks in their portfolios to give them the
least risk possible, consistent with the return they seek.
This theory tells us that diversification minimize risk while increase returns
 04
DIVERSIFICATION
IN PRACTICE
DIVERSIFICATION
IN PRACTICE
Is there a point at which diversification is no longer a magic
wand safeguarding returns?

Increases in the number of holdings do not produce much

additional risk reduction.
GLOBALIZATION: INTERNATIONAL
CORRELATION
 Thanks!
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