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Modern Portfolio Theory
A prestigious standard for diversification
The question of how to protect capital and better still, make it work, is not new. In the ‘Merchant of Venice’, William Shakespeare explains how the merchant always spreads his goods across different ships. That way, if something were to happen to one of the ships, he wouldn’t lose all his goods in one go …
We could go back even further in time. The Jewish bible, the Talmud, states, for instance, that the best thing to do is to spread your money across gold, goods and land. If things go wrong with one of these three, losses will hopefully be compensated by the other two.
Clearly, there has been a consensus about the fact that diversification is a good idea for a long time.
Nobel Prize in Economics
The question is how to diversify. Not every asset class carries the same risks so it is probably not sensible to spread capital proportionally. Harry Markowitz and William Sharpe were the first to quantify this gut feeling. In 1990, they were both awarded the Nobel Prize in Economics for this.
You could say that Modern Portfolio Theory is the philosophical opposite of traditional stock picking. These days, Modern Portfolio Theory is a widely accepted model for managing diversified portfolios at virtually every private bank.
Harry Markowitz
Buy the haystack, not the needle
The investment committee, advised by a respected academic panel, identified several asset classes. A cost-efficient tracker has been selected for each of these classes. Trackers are funds that track an underlying stock market index. Their advantage is that they provide an extra level of substantial diversification.
Modern Portfolio Theory allows for the optimal mix of the selected trackers to be determined as well as the ‘efficient frontier’. This ‘efficient frontier’ is the collection of portfolio constituents with a maximum return for a certain risk level. Market movements or performances of the tracker can, of course, result in a portfolio deviating from this efficient frontier. In such cases, the portfolio has to be rebalanced.