Markowitz’s Theory Explained (Modern Portfolio Theory)

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What is Markowitz’s theory about investment portfolios? How can diversification of stocks reduce risk?

Harry Markowitz’s theory (Modern Portfolio Theory) suggests that the diversification of a stock portfolio can reduce risk. It asserts that a diversified portfolio—one that features holdings in a variety of industries and countries—is more likely to be profitable than a homogenous one.

Find out more about Markowitz’s theory below.

What Is Markowitz’s Theory? (Modern Portfolio Theory)

Developed by Nobel Prize–winning economist Harry Markowitz, MPT in its purest form uses complex mathematics to diversify a portfolio in such a way that it earns a particular return with the smallest amount of risk. Here’s some more information about Markowitz’s theory:

Risks and Rewards

The EMH would seem to indicate that it’s impossible to make money in the market, because whatever you know about a stock has always already been factored into its price. Yet people make money investing in stocks every day—in fact, the best long-term study comparing the most common investment vehicles (stocks, bonds, Treasuries) found that common stocks provided the best returns. What gives?

According to the new investment technologists, money isn’t made in the market by virtue of the strength of information or analysis, but rather the appetite for risk. That is, those who are willing to assume more risk stand to reap greater rewards.

Economists of finance typically define risk in terms of returns’ “variance” from the mean return. Simply put, the more widely dispersed real returns are around the average, the more risky the stock. For example, consider Stock 1, whose returns over the last three years are -5%, 0%, and 5%. The mean return for Stock 1 is 0%. Now examine Stock 2, whose returns over the last three years are -25%, 3%, and 22%. The mean return for Stock 2 is also 0%, but the variance is greater due to the wider dispersion around the mean—that is, an investor in Stock 2 will be assuming more risk. 

How Markowitz’s Theory Manages Risk

Essentially, Markowitz’s theory mitigates a portfolio’s overall risk by offsetting the risks of certain stocks with those of other stocks. These various levels of risk are determined by analyzing the “covariance”—that is, the relative variance—between two or more stocks and deducing a “correlation coefficient”—a single number between 1 and -1 that defines their relation.

For example, take two stocks, one an airline company, another a commercial aircraft manufacturer. If real-world events—say, a global pandemic—severely reduce consumers’ air travel, both stocks will suffer (because demand for both companies’ products will drop). A parallel relationship between two stocks means they’re positively correlated—if one goes up or down, the other will go up or down. Positively correlated stocks, of course, have positive coefficients.

Now take an airline company and a company that provides video-conferencing software and services. When the global pandemic curtails travel, the airline company’s stock suffers—but the video-conferencing-software company’s stock rises (because consumers who would otherwise travel for business now have to hold meetings digitally). These two stocks are negatively correlated—when one goes up, the other goes down (and vice versa). And, no surprise, negatively correlated stocks have negative coefficients.

What Markowitz’s theory discovered is that for any pair of stocks with a coefficient less than 1—in other words, for any pair of stocks whose relationship isn’t perfectly parallel—some amount of risk reduction is possible. This is because stocks with less than perfect correlation may have loss-mitigating responses to market downturns.

MPT in Practice

What does Markowitz’s theory look like in terms of actually constructing a portfolio? Diversity in terms of industry is key, especially when investing in U.S. equities. A common benchmark in terms of diversification is 50 U.S. stocks, equally sized and operating in a range of industries.

However, scholars have found that diversification in terms of industry can only get you so far. In fact, studies have shown that 50 is a kind of magic number: A portfolio of this many (equally sized and well-diversified) stocks reduces risk by over 60%, but the further addition of US equities has little to no effect on risk reduction.

To reduce risk further, investors have to look beyond U.S. stocks—they must diversify geographically and in terms of asset class as well.

The Advantages of International Diversification

Financial analysts have often noted that global markets move in the opposite direction of U.S. markets. Take, for example, a jump in the price of oil. This sort of event can have a negative effect on countries with a large industrial sector or high demand for fuel, for example Europe, Japan, or the U.S. But it can also have a positive effect for oil-producing firms in the Middle East and Southeast Asia.

An analysis of portfolios with various combinations of U.S. and EAFE (developed foreign country) stocks illustrates the point. From 1970 to 2017, EAFE stocks boasted a better average annual return than the S&P 500, though the stocks were more volatile year to year. It turns out that during that period, a portfolio with 82% U.S. stocks and 18% EAFE stocks provided the highest returns with the lowest volatility. That is to say, adding some degree of specific risk to the portfolio actually reduced the portfolio’s risk overall.

The Advantages of Asset-Class Diversification

With greater globalization has come higher correlation coefficients among US and international stocks (though geographical diversity in your portfolio can still mitigate risk). An additional measure that can offset risk is holding bonds as well as stocks among your investments.

For example, during the financial crisis of 2008, when returns on stocks plummeted and retirement wealth evaporated, Barclays bond index fund had a 5.2% return. Bond markets can provide returns when stocks go haywire.

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