In 1952 Yale professor Harry Markowitz published a study now regarded as the origin of the modern portfolio theory (MPT). His work revolutionized the INVESTMENT world and won him a Nobel Prize. According to Dr. Markowitz, RISK was as important as return. Investors, considering the risk/return tradeoff, had a higher probability of making more money over the long term. Before this concept was revealed, investors generally measured the desirability of an investment solely by its expected return in the short term. They subsequently used the new discovery to construct better portfolios. If risk versus return could be calculated, then ASSETS could be distributed in a way that could maximize returns and minimize RISK for various investors’ unique goals. In modern portfolio theory, return is measured by a percentage gain over a period of time; risk is measured by the percentage of fluctuation (or deviation) from the particular investment’s average rate of return. A good investment might demonstrate a return of 20 percent and a standard deviation of 15 percent. A less-desirable investment might have a 10-percent return and a 20-percent standard deviation. If the risk/return characteristics of various investments are known, then the MPT practitioner should be able to find the optimum mixture of assets for the client’s objectives, providing the highest possible return for the amount of risk the client could accept.
The MPT framework has created the following terminology.
• capital asset pricing model, the investment equation that establishes the expected return link to the risk of the investment (beta)
• capital market line, a graph showing the risk/reward relationship for a portfolio of risky assets when combined with a risk-free asset
• efficient frontier, a graph that represents various combinations of assets plotted so that a maximum expected return is shown for each incremental risk level
• optimal portfolio, the portfolio that maximizes an investor’s expected return within the investor’s given level of acceptable risk
• security market line, a graph showing the relationship between “systematic risk” and return for investment.
Rick Lockett