Modern portfolio theory – building a portfolio unique to your circumstances
Old Mutual Wealth's approach to investments is based on Modern Portfolio Theory.
Professor Harry Markowitz published his doctoral thesis ‘Portfolio Selection’ in 1952, marking the beginning of what is known as MPT. He demonstrated that for every level of risk it is possible to construct an investment portfolio that, mathematically, delivers the maximum investment return.
A portfolio constructed according to MPT will place the portfolio on an ‘Efficient Frontier’ where for every level of risk there is a portfolio with the highest expected return and for every level of return there is a portfolio with the lowest anticipated risk.
MPT states that portfolios which do not lie on the Efficient Frontier are inefficient (as otherwise you can get higher returns for the same risk). Hence, the asset allocation process should first establish the level of risk to which clients are prepared to expose their investment, and determine a portfolio that lies on the Efficient Frontier.
Variation in portfolio returns – where have they come from?
More recent research by Brinson, Singer and Beebower has shown that by far the most dominant contributor to the variability of total portfolio returns is the asset allocation of that investment portfolio (that is, the proportion held in shares, property, bonds and cash). According to this seminal study on the subject, asset allocation, on average, accounts for 91.5% of the variation of portfolio returns over time (see the pie chart below). Subsequent studies have realised similarly significant results.
The ideal asset allocation differs from investor to investor and is based on the level of risk each investor is prepared to accept. The Old Mutual Wealth portfolio construction tools provide an asset allocation appropriate for an investor’s investment risk profile that, according to the theory, should provide maximum returns for that level of risk.