Modern Portfolio Theory
Protect yourself from risk.
Any seasoned investor, or even someone new to the scene, understands that there is an amount of risk that goes into an investment. Market volatility can be caused by a variety of factors, from social and economic issues in a country to inflation. No matter the reason, when you invest your money into an asset, identifying risks and providing strategies to avoid them plays a key role in wealth management and financial planning. Investors want to keep in mind how much they may lose if a deal goes sour or a market crashes.
Throughout the Alpenrose literature, you may find Modern Portfolio Theory mentioned. Unless you are a proficient investment expert, you may find yourself asking what that is. To help you out, we’ve decided to shine a light on the topic.
Modern Portfolio Theory
Modern Portfolio Theory, or MPT, is a way investors can lower their risk by constructing portfolios that optimize returns. By examining a given level of risk and knowing that risk is an inherent part of investment, Modern Portfolio Theory allows you calculate ways to continue to gain with your investments.
The theory was developed by Harry Markowitz in a paper titled “Portfolio Selection” in the Journal of Finance in 1952. While a graduate student, Markowitz was looking for topics for his doctoral thesis when he came across a stock broker that inspired him to write about the market. He noticed there was no consideration to the risk of a particular market, so he took it into his own hands.
In this theory, risk-averse investors can construct a portfolio that maximizes return. The main point of the theory is that it’s not about simply picking stocks. It’s about picking the right combination of stocks. By calculating the risk and return for more than one kind of investment, you can use a diverse portfolio to lighten the hit when a risk comes to life.
MPT is one of the most heralded and widely used ways of risk management. As you’ll read below, the key to Modern Portfolio Theory is choosing assets that are not correlated. When you build your portfolio with investment classes that don’t interact, you will find that the volatility in each class will not affect one another. While one investment may be slowing or decreasing in value, your other assets may stay strong, as well as your returns.
There is a variety of financial risks you will want to avoid. This includes liquidity risk, credit risk, asset-backed risk, foreign investment risk, and currency risk.
Systematic vs Unsystematic Risk
Specific risk, diversifiable risk, business risk, and residual risk are all different names for what is known as unsystematic risk. This kind of risk can happen in the company or investment you put your money into. It refers to the possibility that the issuer of the stock could go bankrupt. It is specific to each individual industry or company. Examples of this risk include loss of labor, weather conditions, nationalization of assets, and more. Unsystematic risk can be reduced through diversification.
Systematic risk can also be called market risk, undiversifiable risk, or volatility. This is the kind of risk that lies in the uncertainty that is inherent in an entire market or market segment. It can take place in the form of day-to-day fluctuations in stock prices. It measures the behavior of the fluctuations rather than giving a reason for the change. This kind of risk cannot be reduced by diversification.
Any successful investor will tell you that the key to making money is not losing it. That is easy for anyone to understand. The harder part is understanding the best risk management strategies to apply to your financial situation. Like most financial planning, there is no perfect formula that everyone can adhere to in order to avoid the most risks.
According to Modern Portfolio Theory, diversification is one of the cornerstones of a successful portfolio. In fact, diverse portfolios outperform a concentrated one. By owning a large number of investments in more than one sector or asset class, investors can protect themselves from unsystematic risk, the risk that one encounters when investing in one particular company.
If there are 12 or more stocks in a stock portfolio, unsystematic risk is almost completely eliminated. Systematic risk is always lurking, however. By investing in non-correlating assets, you can protect yourself from volatility.
Non-correlated asset classes are investments like bonds, commodities, currencies, real estate, fine art, and cars.
The non-correlating assets fight volatile markets because each asset class reacts differently to changes in the markets. You will find that there will be times when one asset is not performing well, while another may be thriving. Investors who keep this in mind receive a balanced return and skip the highs and lows of a poorly performing market.
Alpenrose Wealth Management International AG, the sister company of Alpenrose Wealth Management AG, is now a registered investment advisor with the U.S. Securities and Exchange Commission (SEC). Together with our partner Swiss private banks, our company can now offer the full Swiss private banking experience to American clients, both resident and non-resident.
Building on many years of experience in private banking in Switzerland, Alpenrose Wealth Management International AG provides investment advisory services to U.S. clients. Swiss banking is highly regarded around the world, well known for being sophisticated and discreet. In 2017, it was reported that $7.5 trillion in assets are held in Swiss banks and almost 51% of that is generated from clients outside of the country. Choosing Switzerland as a banking destination is choosing years and years of financial stability and growth.
The advantages of having an account in Switzerland include currency and investment diversification, asset protection, and the possibility to deposit assets in some of the oldest and best capitalized banks in the world.