In order to be successful, an investor must understand and be comfortable with taking risks. Creating wealth is the object of making investments, and risk is the energy that in the long run drives investment returns.
Modern portfolio theory has one, and really only one, central theme: “In constructing their portfolios investors need to look at the expected return of each investment in relation to the impact that it has on the risk of the overall portfolio”. The practical message of portfolio theory is that sizing an investment is best understood as an exercise in balancing its expected return against its contribution to portfolio risk- In an optimal portfolio this ratio between expected return and the marginal contribution to portfolio risk of the next pound invested should be the same for all assets in the portfolio
Unfortunately, many investors are not aware that such insights of modern portfolio theory have direct application to their decisions. Too often modern portfolio theory is seen as a topic for academia, rather than for use in real-world decisions. For example, consider a common situation: When clients of a firm decide to sell or take public a business that they have built and in which they have a substantial equity stake, they receive very substantial sums of money. Almost always they will deposit the newly liquid wealth in a money market account while they try to decide how to start investing. In some cases, such deposits stay invested in cash for a substantial period of time. Often investors do not understand and are not comfortable taking investment risks with which they are not familiar. Portfolio theory is very relevant in this situation and typically suggests that the investor should create a balanced portfolio with some exposure to public market securities (both domestic and global asset classes), especially the equity markets.
MODERN PORTFOLIO THEORY EXAMPLE
Imagine you are investing in a tiny country that has only two industries and two seasons. It has an alpine resort and a beach club. When the weather is good, the beach club does well, and when the weather is bad, the alpine resort booms. The returns for the two resorts are:
|Weather | |Alpine resort |Beach Club | |Good Weather | |-30% |60% | |Bad Weather | |60% |-30% |
If the probability of a particular season having good or bad weather is one in two, investing in the alpine resort would produce return of 60% half the time, and -30% half the time, giving an average, or expected return, of 15%; the same is true for investing in beach club. It would be risky, though, to invest in only one of the resorts because there might be many seasons one after other with the same weather, just as you might get a long row of head when flipping a coin.
If you invested £100 in each of the resorts, your result over five seasons might be as followed
|Season |Alpine Resort |Beach club | | | | | | | |Good |-30 |60 | | |Bad |60 |-30 | | |Bad |60 |-30 | | |Bad |60...