Modern Portfolio Theory for RoboAdvisers

This article was originally published at AltFi.com.

The digital asset management space or 'the RoboAdvisors' have embraced Modern Portfolio Theory (MPT) as the underpinning of their risk management and portfolio selection process, and indeed many traditional asset managers refer to MPT-style techniques as the basis of their asset allocation framework.

So to develop an understanding of robo-advice, it is wise to understand Modern Portfolio Theory, its explanatory power and its limitations.

The conceptual beginnings of MPT were introduced to the world in a 1952 essay by a 24-year-old graduate student at the University of Chicago, Harry Markowitz. Who in 1990, for this and further articles in finance and economics was awarded the Nobel Prize for Economics (or more properly the Bank of Sweden Award in Memory of Alfred Nobel).

Historically, security-selection models focused primarily on the returns generated by investment opportunities. Financial analysis was concerned with identifying those securities that offered the largest return for a unit of risk and then constructing a portfolio from these.

There was little discussion of the effect of individual investments on the portfolio. Investment was not ‘holistic’, but there was some understanding of the benefits of diversification.

Markowitz himself said; quoting Shakespeare in the Merchant of Venice;

‘My ventures are not in one bottom trusted,

Nor to one place; nor is my whole estate

Upon the fortune of this present year;

Therefore, my merchandise makes me not sad.‘

This passage shows an intuitive understanding of the concept of covariance, and diversification through time, investment, and geography.

Despite its age, many of the base concepts of Finance are implicitly included. Markowitz’s contribution was not then to introduce the concept of diversification to portfolio analysis, but to look at the effect of risk and return holistically and then quantify those effects more rigorously than previous financiers.

The original 1952 Markowitz paper showed that as you add assets to an investment portfolio the total risk of that portfolio - as measured by the volatility of the portfolio’s value (or standard deviation) - declines continuously, but that the expected return of the portfolio which is a weighted average of the expected returns of the individual assets need not be compromised.

In other words, by investing in portfolios rather than in individual assets, investors could lower the total risk of investing without necessarily sacrificing return, this is considered the one free lunch in Finance.

Harry Markowitz summed up his discoveries rather neatly.

‘Don’t put all your eggs in one basket.’