Modern Portfolio Theory

A statistical technique used to show how a diversified portfolio of assets, such as stocks, can reduce risk and improve the portfolio performance. The theory suggests that the risk of an [Page 328]individual asset or stock should not be considered on the basis of its volatility or variation from its expected return. Instead, it should be considered in relation to its incremental or marginal contribution to the total risk of a portfolio of assets or stocks. The addition of an asset to a portfolio will affect the portfolio's risk depending on whether the individual asset has a negative or positive correlation to the price movements of the individual assets in the portfolio. Modern portfolio theory was first developed in 1952 by Harry Markowitz by applying mathematics to stock analysis. The theory was later refined and further researched by Sharpe, Miller, Fama, and others. The main idea behind this theory is that an investor can reduce the risk of and improve the expected return of a portfolio of stocks if the stocks in the portfolio are not correlated in their variability of returns to each other. For example, a portfolio should consist of stocks from different industries and in sufficient quantities to take advantage of diversification. The idea is to pick stocks in different industries that move in opposite directions. For example, if there is a recession in the automobile industry and there is a boom in the telecommunications industry, then stocks in a portfolio that fall in prices in the automobile industry will be negated by the stocks in the telecommunications industry. For further reading, see Ehrhardt and Brigham (2003), Emery, Finnerty, and Stowe (2004), and Markowitz (1952).