Page 145 - A Canuck's Guide to Financial Literacy 2020

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Modern Portfolio Theory

Modern Portfolio Theory is an investment theory that was put forward by famed economist
Harry Markowitz in 1952. He stated that risk-averse investors are able to create portfolios
that will allow them to maximize their expected return based on their level of market risk. He
emphasized that the higher the risk, the higher the return. His investment theory was a
breakthrough in portfolio management and demonstrated that purchasing a basket of
securities would result in lower volatility than purchasing just one, the essence of
diversification.

Risk Aversion

Modern Portfolio Theory states that the investors, at heart, are risk averse. If they had to
choose between two portfolios that offer the same rate of return, a rational investor would
choose the one with the lowest risk. Investors would be willing to take on higher risk if only it
can yield higher expected returns. However, each investor will evaluate the trade-off
differently based on their risk appetite and their attitude towards risk.

Expected Return of MPT

MPT states that the expected rate of return of a portfolio is a weighted average of individual
returns.

Portfolio Weighting Example: You have $2,000 to invest in Pepsi and Coca Cola stocks. If
you invest $1,000 in Pepsi and $1,000 in Coca Cola, then the weight of Pepsi is
$1,000/2,000 = 50%. The weight of Coca Cola is $1,000/$2,000 = 50%. This is an equally
weighted portfolio of two stocks.