Modern Portfolio Theory (MPT) earned its pioneer Harry Markowitz the Nobel Prize in economics in 1990.
And the investment methodology continues to serve both institutional and individual investors well through all kinds of markets.
MPT allows us to construct an optimal portfolio taking into consideration the relationship between risk and return. One of MPT’s principles states that the more risk you are willing to take on, the greater the returns you are likely to achieve.
So once we know your particular level of risk, we can construct a portfolio that maximises the expected return of that portfolio for a designated level of risk.
Another of its principles states that asset class diversification is crucial to enlarging your returns for the amount of risk that you are comfortable accepting. Under MPT therefore, it is incorrect to consider the potential returns and risks of just a single stock.
This can be illustrated in the following example. A portfolio has two stocks: one that does well when it rains and another that performs well when it doesn’t rain. This means that the portfolio will realise gains come rain or shine. Although this is a simplified example of diversification, it also highlights the importance of choosing the right combination of assets to diversify a portfolio.
InvestEngine is designed to allow you to reap the true benefits of diversification, offering ways to invest in a blend of asset classes, industries, companies and countries to lower your overall market risk. This is because no single asset class performs best in all economic environments and different asset classes tend to react differently to the same event.
Having a diverse portfolio will – by definition – be inherently less risky than holding just a single stock. That is why ‘don’t put all your eggs in one basket’ is sound investment approach that we always apply to your portfolio.
And it is why we use exchange-traded funds (ETFs) – which can track anything from stock indices to stock market sectors, commodities, currencies and bonds – to help us achieve true diversification.
In addition, long-term market data continues to validate MPT. It even performed better than most other strategies during the financial crisis. Of course, MPT does not protect you from losses in all markets and does not claim to be able to mitigate ‘systemic risk’. But MPT investors who held fully diversified portfolios saw their losses in 2008 cushioned by holding certain asset classes that weathered the financial storm better.