The premise of the modern portfolio theory (MPT), proposed by Harry Markowitz in 1952, is diversity. Murphy Choy says that means you should “never put all of your eggs in the same basket.” According to Choy, the theory was never meant to be used with complex investment products because they behave differently from stocks. In Choy’s NESUG 2011 presentation and paper, Choy explains the modern portfolio theory and who should use it.
According to Choy, investors with a lot of money to invest probably don’t need to use the modern portfolio theory because they will be investing over a long period of time and can ride the ebbs and flows of the market. “But for the bulk of us,” says Choy. “We need something that is more predictable.”
How does it work?
Choose a diverse portfolio of stocks, so that the volatility of the individual stocks will work to counteract – almost balance overall price volatility of the portfolio and contribute to the stability of the portfolio. According to Choy, if you can reduce your volatility, you can almost guarantee a certain rate of return.
Does it really work?
In practice, there are a few problems with the theory. It also depends on the market operating in a dependable manner. The modern portfolio theory assumes that the market is very efficient. Choy’s paper includes a macro that you can use to download stock picks from Yahoo to experiment with or build your own portfolio. Play around with it before you assign real money to it. Let me know how it works out.