1952 was the year modern portfolio theory and construction was founded. It all began with Harry Markowitz's paper on the mean-variance optimization (MVO, Markowitz, 1952). The essence of his paper outlined how investors could efficiently allocate assets so they could achieve the highest return for a given level of risk (standard deviation). Following his initial paper, Markowitz developed the modern portfolio theory (Markowitz, 1959), in which he outlined some of the key aspects still widely-used in professional finance today. The key concepts included:
- Risk is measured as standard deviation.
- The concept of the Efficient Frontier.
- Employing the concept of covariance and diversification leads to better risk-adjusted returns, especially when uncorrelated assets are included in a portfolio.
The approaches outlined by Markowitz were merely theoretical, with several limitations. One of these limitations include that the mathematical optimization of a Markowitz portfolio leads to high asset class concentration if we do not work with constraints.
The Next Steps
The next larger step in modern portfolio theory was the development of the Capital-Asset-Pricing-Model by Treynor, Mossin, Lintner and Sharpe in the 1960s. The CAPM was a further step for investors and academia to understand the connection between asset risk and asset returns. Specifically, the CAPM introduced the concept of distinguishing between two types of risk, namely the systematic risk (that is risk that we cannot diversify away in portfolio construction, no matter how much we diversify) and the non-systematic risk (that, on the other hand, is risk we can indeed get rid of by diversifying our portfolio). The CAPM also introduced two other new concepts now widely-used in finance: alpha and beta. We use the word "alpha" when we talk about achieving or aiming at returns that are better than the overall market, and "beta" when we refer to the returns that the market gives us.
1976 marked the next year in the ongoing development of modern portfolio theory when Stephen Ross published the Arbitrage Pricing Model (APT) which looked into several sources of systematic risk.
In 1987, the Wall Street crash and the Asian currency crisis hit investors hard. New types of risk were suddenly appearing and investors started to look for new answers. Specifically, the events of 1987 increased the focus on so-called tail risk (those are risks that happen rarely, but if they do they are detrimental to portfolios. "Tail" refers to a distribution of returns, e.g. for the S&P 500, and the (negative) returns that occur on very special occasions in which the stock market plunges excessively).
As a result, more research was put on so-called "market anomalies". This was also the time when the "Value-At-Risk" approach was introduced and slowly taken over by institutional investors as a risk evaluation approach.
The "tail events" of 1987 furthermore lead to the advent of futures and options as portfolio insurance mechanisms. Investors started realizing that due to the nature of futures and options, they were well-suited to protect against rare but harsh market collapses at a relatively low cost.
In this era, we also saw the emergence of hedge funds, which entered the financial community by promising investors returns that are independent from the market and thus independent from severe crashes.
In 1992, two researches named Fama and French offered another framework that argued that size, value and market risk could help explain market returns. Based on this research and the ensuing improvements over time, we saw the advent of so-called "smart-beta investing", which essentially promises investors that there are factors in the (stock) market that offer superior returns without circular reasoning.
1992 also saw the introduction of the Black-Litterman Model, developed by Fischer Black and Robert Litterman. The Black-Litterman Model was designed to overcome the limitations of the classic Mean-Variance Optimization by starting the optimization process from a market-cap weighted portfolio and then adjusting it for so-called "view returns" (i.e. return assumptions for each asset class - both absolute and relative views) by the investor. Due to the mathematical nature of the Black-Litterman formula, high asset class concentration can be avoided.
The 2007 World Financial Crisis and The Effect on Portfolio Theory
In 2007, the financial world seemed close to collapsing when first Lehman Brothers, and then several other big institutions felt the materialization of risk they engaged in with mortgage-backed securities and highly-leveraged insurance swaps.
For modern portfolio theory, one thing was especially worrisome: The high correlation between assets during the meltdown, which saw many asset classes collapse in tandem and many investors did not have enough asset classes in their portfolios to offset the meltdown in stocks, corporate bonds and high-yield products.
This gave rise to so-called tactical asset allocation, in which investors and hedge funds argue that it's useful to operate based on indicators and adaptive trigger systems. Unfortunately, most hedge funds and investment management companies implementing this approach fail to generate meaningful return for their investors.
Also, Risk Parity (meaning that each asset in your portfolio should contribute the same level of risk) emerged during that time.
Another concept that emerged during that time was the concept of "Behavioral Finance", in which investment management companies try to beat the market by essentially guessing how other market participants act. However, since a behavioral finance department is pretty much standard in all larger organizations today, the effects are negligible.
Based on this short overview over the main steps in modern portfolio theory, the conclusions can be summarized as follows:
- Risk and Reward are two concepts that should be analyzed for each and every investor distinguishedly. What suits one investors can never suit other investors.
- Diversification is the only long-term source of stable returns and fulfilling your financial goals.
- Applying your asset allocation via low-cost index funds (ETFs) and by avoiding expensive managers that usually do not generate superior returns is more important that ever before.