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The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any single one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio.

Markowitz showed that investment is not just about picking stocks, but about picking winners, i.e. choosing the right combination of stocks among which to distribute one’s nest eggs.

Two Kinds of Risk

MPT states that the risk for individual stock returns has two components:

Systematic Risk – These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.

Unsystematic Risk – Also known as «specific risk», this risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio (see Figure 1). It represents the component of a stock’s return that is not correlated with general market moves.

For a well-diversified portfolio, the risk of each stock contributes little to portfolio risk. Instead, it is the difference – or covariance – between individual stocks’ levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks.

The Efficient Frontier

Now that we understand the benefits of diversification, the question of how to identify the best level of diversification arises. Enters the efficient frontier.

For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line is the efficient frontier. Figure 2 shows the efficient frontier for two stocks – a high risk/high return technology stock (Google) and a low risk/low return consumer products stock (Coca Cola).

Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected return for a given level of risk. A rational investor will hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.

Figure 1

MPT takes this idea even further. It suggests that combining a stock portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which is funded by borrowing, can actually increase returns beyond the efficient frontier. Thus, if you were to borrow to acquire a risk-free stock, then the remaining stock portfolio could have a riskier profile and, therefore, a higher return than you might otherwise choose.

Figure 2

What MPT Means for You

MPT has had a marked impact on how investors perceive risk, return and portfolio management. The theory demonstrates that portfolio diversification can reduce investment risk. Modern money managers routinely follow its precepts.

However, MPT has some shortcomings in the real world. It often requires investors to rethink notions of risk. Sometimes it demands that the investor take on a perceived risky investment (futures, for example) in order to reduce overall risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated portfolio management techniques. Furthermore, MPT assumes that it is possible to select stocks whose individual performance is independent of other investments in the portfolio. But market historians have shown that there are no such instruments; in times of market stress, seemingly independent investments do, in fact, act as though they are related.

Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio returns, but finding a truly risk-free asset is another matter. Government-backed bonds are presumed to be risk free, but, in reality, they are not. Securities such as gilts and U.S. Treasury bonds are free of default risk, but expectations of higher inflation and interest rate changes can both affect their value.

Then there is the question of the number of stocks required for diversification. How many is enough? Investment guru William J. Bernstein says that even 100 stocks is not enough to diversify away unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book «MPT and Investment Analysis», conclude that you would come very close to achieving optimal diversity after adding the twentieth stock.

Conclusion