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Modern Portfolio Theory

Passive and index mutual fund investing isn’t just another investing idea. It’s grounded in a body of Nobel Prize-winning research and peer-reviewed academic studies based on modern principles of 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 risk reduction 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 for Economics in 1990.

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). CRSP 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 not 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

In an influential paper published in 1992, Professor Eugene Fama (University of Chicago) and Professor Kenneth French (Dartmouth College) concluded that taken together four explanatory variables: the risk factor of the market (Beta), company market value, company price-to- book value ratio and company profitability do the best job of explaining stock returns. The stock market is riskier than Treasury bills, therefore investing in the stock market offers higher expected returns than investing in Treasury bills. Small cap stocks (company size) are riskier than large cap stocks, so investing in small cap stocks offers higher expected returns then investing in large cap stocks (Banz 1981). Value stocks are riskier than growth stocks, so investing in value stocks offers higher expected returns then investing in growth stocks. More recently, valuation theory and rigorous empirical research suggests "Cash Flow" or "Profitability" as another source of expected return across stocks beyond the information contained in the dimensions of company size and relative price.  With respect to fixed income investing, the Fama and French research concluded that two additional factors, maturity and default risk, explain the risk and return characteristics of fixed income securities.

Over time, hundreds of studies have rigorously analyzed the Fama and French explanatory variables, and in the final analysis the Fama and French results have been validated. Most researchers conclude that the size, book-to-market and profitability effects are real, since they have been observed over several decades in the U.S. and other countries as well.

Passively oriented index mutual fund and ETF investment advisors like Cardiff Park Advisors use the tools of Modern Portfolio Theory to build and maintain low-cost, low-turnover investment portfolios that optimize returns for a given level of risk.

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