Modern Portfolio Theory
Passive investing is grounded in a wide body of Nobel Prize winning financial and economic academic research based on modern principles in finance. One of the earliest discoveries is credited to economist Harry Markowitz.
In the early 1950’s Markowitz found that by mathematically combining the expected risk & return for each of the securities in a portfolio and the correlation coefficients among them, the expected risk & return for the whole portfolio can be defined. With this information the risk and return characteristics of one portfolio can be compared with the risk and return characteristics of another portfolio.
Markowitz demonstrated that proper diversification can lead to reduced risk and increased return. The optimal balance of risk and reward for each investor can be found on what Markowitz called the “efficient frontier.” The process of finding the ideal portfolio among thousands of possibilities is called “portfolio optimization.” Markowitz's research suggests that investors should focus less on the characteristics of individual portfolio risks and more on the combined impact of all risks on overall portfolio performance. For this, and the conceptual framework on which it is based, Markowitz shared the Nobel Prize.
Center for Research in Security Prices
Academic financial research accelerated in 1960 with the founding of the University of Chicago’s Center for Research in Security Prices (CRSP), which modernized the field of security analysis by establishing a massive database tracing security prices, dividends, and rates of return on all NYSE stocks going back to 1926. This treasure trove of data opened the doors to modern-day academic financial research.
Capital Asset Pricing Model
In 1964, William Sharpe advanced Modern Portfolio Theory with the Capital Asset Pricing Model (CAPM). The CAPM says investors can get increased expected return but only buy accepting a proportional amount of increased risk. According to Sharpe’s theory, just taking any risk merely to take risk does not increase your long run expected return. You need to invest in specific types of risk and you need to diversify your risks. That is, you can’t get an increased expected return investing in an un-diversified asset that fluctuates widely. Sharpe’s theory says that if there are true values for all expected returns, standard deviation, and correlation coefficients, then given your preference for risk, you could calculate the exact optimal portfolio to invest in. This would be the optimal portfolio for all investors.
Practical Application of Modern Portfolio Theory
You have to make a decision on how much risk to take. The Markowitz/Sharpe theory says:
- Choose an equity portfolio which should be a broadly diversified index fund
- Decide on the division between stocks and bonds.
- Invest the equity portion in the most broadly diversified equity market portfolio including not only US stocks, but also foreign stocks.
Sources of Expected Return
Today passive investors use the tools of modern research to build and maintain low-cost, low-turnover, index oriented portfolios that optimize returns for a given level of risk. In an influential paper published in 1992, Eugene Fama (University of Chicago) and Kenneth French (Dartmouth College) concluded that taken together the risk factor of the market (Beta), the company market value, and the company stock price to book-value ratio do the best job of explaining stock returns. The stock market is riskier than Treasury bills therefore the stock market has an expected premium over Treasury bills. Small cap stocks are riskier than large cap stocks, so small cap stocks have an expected premium (Banz 1981). Value stocks are riskier than growth stocks, so value stocks have a higher expected premium. Fama and French research also concluded that two additional factors, maturity and default risk, explain the risk and return characteristics of fixed income securities.
Challenges to Fama & French
Hundreds of researchers have since rigorously analyzed Fama and French explanatory variables and in the final analysis provide further evidence to the validity of their original results. Based on the papers that support the Fama and French results, most researchers conclude that the size and book-to market effects are real, since they have been observed over several decades in the U.S., and in other countries as well.