Many professional advisors tout the benefits of Modern Portfolio Theory, i.e. a diversified portfolio with the lowest possible risk to reward ratio. Harry Markowitz received the Nobel Prize in 1990 for developing this theory. The individual investor, however, should think twice before applying these ideas to his portfolio.
There are several reasons why MPT works for large investment vehicles like mutual funds, but can be toxic to smaller portfolios like yours.
1) The way we often measure risk-to-reward is not as robust as it sounds. Think about what risk really is: it’s the amount you stand to lose. We often quantify risk by volatility, or statistical variance, but volatility measures down-side risk, and upside risk as well. Upside risk shouldn’t be included. Volatility isn’t necessarily bad. Risk is, by definition, bad. They are not the same. Think about this: if a particular stock gets overvalued at times (think technology,) that would increase volatility, but it could also make a great exit strategy for you, adding unwarranted returns to your total gain. In this case, volatility is a good thing.
2) The reasons that one stock is volatile and another is not volatile are also complex reasons. Stocks that have lower prices are necessarily more volatile. Take a stock that is worth 50 cents. A one cent rise in price means a 2% gain for you. Take a stock that is worth 50 bucks. A 1 cent rise in price is a 0.02% gain for you. However, neither stock can have a change in price less than 1 cent, so cheap stocks are always more volitile. If volatility is bad, why don't the financial gurus tell you only to buy stocks over $100? That would decrease volatility in your portfolio. It wouldn’t decrease risk, though.
3) A more advanced measure of risk, under MPT, is found when you run a regression of the stock on the market. Then, you end up with two estimates: alpha, the volatility of the stock independent of the market, and beta, the volatility of the stock due to the market. I bet they never told you this: it could occur that a stock never goes down in price, but still has significant values for alpha and beta. I would say that a stock which only goes up has zero risk. MPT would say differently.
4) Oh, but there are so many more problems, as well. Any stock with a high beta has a lot of upside risk (a good thing) during a bull market. However, the same stock has a lot of downside risk during a bear market. Therefore, only someone keeping their funds fully invested throughout all the cycles of the market would actually experience the true beta. The measurement of risk is totally independent of your actual portfolio risk. The difference between MPT and the realities of your portfolio are substantial.
5) Mutual funds commonly use MPT-based strategies. No surprise here: 70% of them under-perform the market.
6) Because of “up-side risk,” your risk measurements are biased upwards for all securities, but not by the same amount for each security. Also, both alpha and beta risks change over time. This makes comparison of risk between two stocks totally invalid. Furthermore, comparison of risk profiles for more than two stocks at a time becomes very complicated and very mathematical, very quickly. The individual investor’s time is better spent learning the business and fundamentals of a company. It’s immensely complex to run the optimization routines necessary to tailor alpha and beta levels to your liking. People who want that sort of math in their strategy are best off letting a quant fund to do it for them. Not that I think it’s useful in the first place.
7) A fourth major flaw is that all risk measurements rely on the past returns of the stock. Well, you're not trying to make money based on past events, you're trying to make money on future events. You will never find the most successful investors talking about what happened. You will find them talking about what is going to happen. The whole concept of basing future returns on past returns is flawed.
I hope you are getting a sense of just how bad the Modern Portfolio Theory touting “professionals” are at giving you advice on your portfolio. They encourage you to diversify away risk, they talk all day about expected returns, I wonder if they even took math after high school. If you are not convinced yet that risk-reward measurements are ridiculous, let me tell you one more reason to stay away from these strategies:
8) If we really followed modern portfolio theory, we would invest 100% of our portfolio in treasury bonds. The risk-reward ratio there is miniscule, because the only risk is inflation risk. In the current U.S. economy, there is zero downside risk to these securities. It doesn’t matter how small the return is, the risk-return ratio is almost zero. So why do people invest in stocks with a higher risk-reward ratio than bonds? They do so, because MPT is not good investment advice, it’s just a theory.