The investments in today’s times are resultant of the award-winning theory proposed by the famous economist, Harry Markowitz. His famous Modern Portfolio theory laid the grounds for the modern-day sophisticated strategies behind investments.
Considered as the father of the modern-day economy, Markowitz explained investments as a driven phenomenon depending upon various factors individual to individual. The basic fundamental of his theory is to reap the best benefits from the investment portfolio even during volatile times. His work is about constructing an investment portfolio which produces optimal returns even when the markets are risky.
What we call today as portfolio diversification, was proposed by Markowitz as combining various fund classes under one portfolio to reap the best benefits. Such a portfolio helps in limiting the risk and maximizing the profit.
There were a few assumptions and key points while concluding this research;
- Investors are risk-averse
The first assumption he took was that the investors are risk-averse by nature. No investor who invests in the stock market never wants the risk to hit his investments. Given the option of a fund with high-risk high return and low-risk low people, the majority of people chose low-risk fund even if the return on that fund was quite lower.
Hence came the conclusion that an investor is more concerned about the risk rather than return and base his investment decisions preferably on the risk profile.
- Types of risks
There are two different types of risks prevalent in the market- systematic risk and unsystematic risk. Systematic risk is the one which cannot be managecjpd like the risk from war, recessions or interest rate. Another type of risk is the unsystematic risk which can be managed by spreading investments across different sectors, industries, geographies, etc. This is called a portfolio diversification.
- Asset allocation
The third important pillar of the theory is asset allocation and portfolio selection. Markowitz claims that the selection of funds and asset allocation plays a vital role in the performance of a portfolio. The selection of funds must be aligned with the long-term financial goal and how they are going to affect each other under one portfolio. While concluding this theory, Markowitz introduced a factor called the efficient frontier. An efficient frontier is a portfolio which covers only the efficient parts of a risk-return spectrum.
Using MPT (Modern Portfolio Theory)
MPT can be used when you go for fund selection and portfolio diversification. The theory suggests allocating assets in different percentages of fund classes. For example, investing 60% of the money in equity funds and 40% in debt funds. the 60% in equities is further classified into sub-categories like large-cap, small-cap, mid-cap funds; commodities, fixed income instruments, etc.
With the use of MPT, investors can benefit even during the market corrections as it has never been the case that all sectors are down at once. There are a lot of industries which are inversely related hence giving an opportunity to the investor to spread funds and reap benefits during all times irrespective of the market positioning.