Practical Lessons from Modern Portfolio Theory

Modern Portfolio theory is a set of tools and theories designed to find or explain the relationship between risk and return. If it works it can help investors to find portfolios that offer the highest return for a given level of risk and it provide a way to calculate the required return on any investment based on its risk level.

After a very close study of these theories I found that much of it is of theoretical interest only and that there is much controversy over which theories are valid and which are not.

But out of a mass of complex theory we can pick out a few fundamental truths that are not controversial and that are of real practical significance to ordinary investors.

1. Higher average historical and expected future returns are associated with higher compensatable risks.

For example it is well established that Bonds on average have higher returns and risks than treasury bills and that an investment in a broad stock market average has still higher long term average returns and a higher risk.

In the long term this can provide a very reliable method for investors to achieve a higher return. But investors have to understand that only certain types of risks are compensated by the market through a higher return.

Some theories hold that only those risks that cannot be reduced by diversification are compensatable. Other theories indicate that some company specific risks may be compensatable. However it seems clear that most company specific risk that are easily diversified away are not compensatable. The market does not reward stupidity such as investing all of your assets in one company.

Note that the way that the market increases the return on riskier assets is for the asset to trade at a lower price than does a similar but lower risk asset. If during a period of irrationality, the market is pricing a particular risky stock very highly, then there is no way for the market to deliver a higher return on this asset. It is irrational (but perhaps not uncommon) for higher risk assets to trade at higher prices than similar but lower risk investments.

2. The higher return for higher compensatable risk implies that the cash flows from an asset with higher compensatable risk should be discounted at a higher rate compared to lower risk cash flows.

The Capital Asst Pricing Model (“CAPM”) provides a theoretical method to calculate the proper discount rate. The risk is measured by looking at “beta” (the correlation of the asset with some total market index). Unfortunately there is much controversy about whether or not CAPM works and there is much evidence that even if it works in theory it is not possible to reliably measure beta and there is no agreement on exactly what constitutes the total market portfolio of all available risky assets. But the point to remember is that the concept of using a higher discount rate for higher non-diversifiable (or compensatable) risk is valid. It is better to be approximately right by guesstimating an appropriate discount rate rather than being precisely wrong by ignoring the risk premium.

3. There is no one “correct” answer for how much compensatable risk an investor should take on. The market provides a certain expected return for each level of compensatable risk. It is up to each investor to select a spot along the efficient curve based on their time horizon and risk tolerance.

It is often claimed that the market return is equivalent to the risk free rate of return on a risk adjusted basis and that an investor should therefore be indifferent between the two. This is not correct, it is up to each investor to decide if the extra expected return on the market justifies the extra risk. Individual investors should and do have strong preferences between the two depending on their circumstances, time horizon and risk tolerance and are absolutely not indifferent.

4. There are significant benefits to diversification of stock and bond portfolios. A non-diversified portfolio includes unnecessary risks that can be easily diversified away with no loss of return.

A broad stock market index is likely to be a more efficient portfolio compared to most other portfolios.

5. An efficient way to adjust your risk level is to allocate a certain portion of your funds to a broad market index (or several indexes including domestic stocks and bonds and possibly foreign stocks and bonds) and to allocate the other portion to a risk free cash investment. The portion allocated to the market index can be more than 100% of your funds if you are willing to borrow funds to invest.

As long as you are willing and able to accept the risk and you can borrow at close to the risk free rate then this can constitute a money machine. Over the long term you can reliably earn a high return. (It is highly probable but never quite certain that you can exceed the market average through this leverage technique). But you must be sure that you will be able to service the debt and will not be forced to sell at an inopportune time.

Unfortunately, there is no consensus on what market index you should invest in. A portion should likely be in bonds but it’s not clear what portion. Some would recommend a large allocation to foreign stocks but after considering exchange rate risk, perhaps the foreign content should not be too high. I believe that the concept of investing or borrowing cash is an excellent way to adjust the risk and return position and that investors have to use some judgment in selecting the make-up of their “market” portfolio. But it should probably consist mostly of an indexed stock fund with some bonds and a smallish parentage allocated to foreign. It’s a case where the theory is not perfect, but by using judgment to select a market portfolio based on broad index funds you can be reasonably sure of getting the market portfolio approximately right, which is better than ignoring this theory altogether and being precisely wrong.

6. Modern Portfolio Theory does not have all the answers. The market does have its inefficiencies.

If there were no market inefficiencies then there would be no sense in trying to pick individual stocks either through value methods, insider information or through analysis of price and volume patterns and momentum. In a perfectly efficient market, the only logical strategy would be to invest in market index funds and use cash investing or borrowing to dial in the desired level of compensatable risk and then accept the associated market return. But, studies have shown that markets are reasonably but not perfectly efficient.

If investors can find methods to reliably find undervalued stocks then a portfolio of such stocks will turn out to be more efficient than portfolios falling along the “efficient” market line. Such inefficiencies can (if found) be exploited to find stocks that offer both high returns and relatively low risk. The most successful devotee of this logic is Warren Buffett.

The ultimate example of this type of inefficiency is an arbitrage strategy where a speedy trader sees that he can buy an asset in one market and simultaneously sell it in another market at a higher price to gain a risk-free arbitrage.

As long as markets are not perfectly efficient there is room for investors to attempt to beat the market. For more on this see my Article, How to Achieve Higher than Average Returns In The Market.

Copyright September 30, 2001