[Theory] Understanding Modern Portfolio Theory (MPT): Diversification and Risk

1. What is Modern Portfolio Theory (MPT)?

Anyone who has entered the stock market has probably heard the saying, "Don't put all your eggs in one basket." However, few know that this seemingly obvious advice is not just a simple proverb, but the result of a great mathematical proof that won a Nobel Prize in Economics.

Modern Portfolio Theory (MPT) is the backbone of financial engineering, originating from a paper published by Harry Markowitz in 1952. Wall Street before Markowitz was strictly an era of 'stock picking'. Investors were solely obsessed with finding "the one jackpot stock that will go up tomorrow," and there was no attempt to mathematically calculate the concept of 'Risk'.

Markowitz introduced the concept of 'Volatility (Risk)' into this barbaric gambling den for the very first time. He mathematically proved that no matter how good the return of a stock is, if you fail to control the volatility (risk) of that stock swinging up and down, you will eventually go bankrupt.

2. 3 Core Principles of MPT

To understand Modern Portfolio Theory, you need to know the following three core concepts.

① The Proportional Relationship Between Expected Return and Risk (Volatility)

There is no free lunch in the investing world. MPT assumes that as the expected return of an investment asset increases, the accompanying risk (price volatility) must also increase. Therefore, a rational investor should not simply chase assets with high 'returns', but must look for "the asset with the highest return relative to the risk I am bearing."

② Correlation Between Assets

The greatest discovery of this theory lies in 'correlation'. Correlation refers to the similarity in the direction in which the prices of two assets move.

• Positive (+) Correlation: Assets that move together, like umbrellas and rain boots selling well when it rains.
• Negative (-) Correlation: Assets that move in opposite directions, like umbrellas selling well when it rains but sunglasses not selling.

Markowitz proved that when constructing a portfolio, it is not important to simply buy many stocks, but you must mix assets that move differently (low correlation) to miraculously reduce the risk (volatility) of the entire account without impairing the return.

③ Efficient Frontier

When you mix numerous assets with low correlations, combinations of 'maximum returns' that we can achieve at a certain risk level are plotted as points. The curve connecting these points is called the Efficient Frontier. A rational investor must choose an asset combination (portfolio) on this curve; investments below this line are merely inefficient gambles with high risk and low returns.

3. Impact on Practical Investing and Limitations

Modern Portfolio Theory has had an absolute impact on the Asset Allocation of institutional investors and pension funds. All modern diversified investing, which mixes stocks, bonds, gold, and the dollar, has its philosophical roots in this MPT theory. As mentioned in Evolution of Investment Chapter 1, this theory was also my first teacher that made me abandon the arrogance of prediction.

However, MPT also had practical limitations. It was nearly impossible to accurately calculate future correlations and expected returns based on past data, and calculating the correlations of millions of stocks in the world one by one was a daunting task even for a supercomputer.

The subsequent theory that solved this complex mathematical limitation at once and drew the ultimate conclusion to buy the 'entire market'—the ultimate boss of diversification—is William Sharpe's Capital Asset Pricing Model (CAPM). In the following article, we will delve into CAPM, the true backbone of index investing.