Modern Portfolio Theory for Investment

When choosing individual portfolio investments, one of the most important considerations is your portfolio’s level of diversification—is your money invested in just a few areas or is it invested broadly across multiple countries, industry sectors and individual companies?

Diversification goes hand in hand with what most investors focus on: the risk-return trade off. How well you spread out the risk—or diversify—in your portfolio will likely influence the amount of short-term volatility you can expect. Investing too heavily in one or two areas of the market means your investment account returns are heavily dependent on the performance of just a few companies and your portfolio may incur more short-term volatility than a well-diversified portfolio.

Modern Portfolio Theory

In 1952, Harry Markowitz received the Noble Prize in Economics for the work in his essay "Modern Portfolio Theory.” This investment management theory contained two major concepts:

  1. The investor’s goal is to maximise returns given the amount of risk that they are willing to take on.
  2. Risk can be reduced by investing in securities that are negatively correlated or whose prices move inversely.

The theory broke important new ground in the way it described how an asset’s risk should be considered within the context of the investment portfolio's overall performance. One important aspect is the concept of blending dissimilar assets—negative or non-correlated assets—to reduce overall risk.

So how can you implement this theory into your own portfolio?

Applying the Theory to Your Own Portfolio

Constructing a well-diversified portfolio is not as easy as investing in a random mix of stocks and bonds. When determining what individual portfolio investments to include, you should be diversifying your investments with dissimilar characteristics. For example, you could include stocks that might move in inverse of each other. Modern Portfolio Theory states that one should look for negatively-correlated investments to reduce risk.

A common misconception is that diversification can only be achieved amongst different asset classes. Diversification comes in many shapes and sizes, and in fact, a diverse portfolio can consist entirely of equities. While this strategy may seem scary, equity investing can be done carefully and responsibly if spread out amongst a wide variety of countries, industry sectors and companies. When diversifying your portfolio, you will want to make sure that you are invested both in areas that you believe will perform well and in areas that you think may not do as well, accounting for if you are wrong.

One of the best ways to diversify your investments is to invest globally, spreading your risk across multiple countries and markets. You should consider the benefits of owning securities across multiple countries and sectors. This approach should help you reduce the volatility inherent in investing solely in any single sector, country or company.

Global Diversification

Canada is just one piece of the total world stock market, yet for Canadian investors, it may be tempting to have it account for all or most of your portfolio investment. However, this kind of home-region investing bias can also create concentration risk—the risk of having too much of your portfolio invested in one area. This increases the risk that if that area of the market underperforms the broader market, so will your returns. Another risk that home-region investors face is potentially missing out on global investing opportunities, such as foreign stock markets and overseas bonds and funds.

Of course, investing in markets always involves some risk and no investment is immune to short-term negative volatility. However, global diversification may help smooth the bumps and reduce some of the short-term volatility inherent in narrower indices: this is an important aspect of applied Modern Portfolio Theory.

Remember that diversifying your portfolio is important even if it seems like your home country’s markets are infallible. Countries and sectors rotate in and out of favour over time, and next year’s top performing countries may not include your own. Failing to invest outside of your home country means potentially missing huge investing opportunities across the globe.

Speak to Fisher Investments Canada Today

It can be difficult to identify the portfolio investments that are right for you, and many investors have trouble simply knowing where to start. If you would like help determining how and where to invest, speak with one of our professionals to see how Fisher Investments Canada may be able to help you achieve your long-term financial goals. Alternatively, if you would like to learn more, download one of our many educational guides.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns.