Modern portfolio theory suggests that a basic element in diversification of risk (with risk defined as the variation of actual returns around an expected return) is allocating the assets in an investment portfolio among categories of investments whose statistical performance correlations to each other are relatively low (or even with no correlation or negative correlation). Statistical correlations measure the extent to which the performance of various asset classes tends to move in the same direction as that of other asset classes (either up or down). A statistical correlation of 0 means there is no relationship in the performance of the two asset classes — they are independent of each other. A positive correlation indicates they tend to move in the same direction. A high positive correlation indicates they tend to move together more closely (to a higher degree), while a lower positive correlation means they tend to move together but to a lesser extent. A negative correlation indicates they tend to move in opposite directions. The statistical correlations are calculated from historical data on the performance (variability) of asset categories. Therefore, as with other historical statistical studies, the historical period used can be significant.
The essential idea is to manage or control portfolio risk (i.e., the variability of returns of the whole portfolio) by allocating the portfolio among uncorrelated asset classes or among asset classes with low correlations. That way, if one asset class, say common stocks, declines, another asset class, say high-yield bonds, may not decline, or may not decline to nearly the same degree, or may actually rise, depending on how correlated the asset classes are.
Thus according to modern portfolio theory, the addition of a higher-return asset class like high-yield bonds to a portfolio which consists, say, mainly of U.S. common stocks and high-grade U.S. bonds will not necessarily increase the overall portfolio risk if there is a low correlation between high-yield bonds and the other asset classes. In effect, this means that the addition of higher-return, more volatile asset classes to a portfolio will not necessarily increase the volatility (risk) of the portfolio as a whole, if the asset classes are uncorrelated or have low correlations.
Modern portfolio theory employs mathematical models to analyze expected returns, volatility, and correlations of individual asset classes. Many sophisticated techniques and investment vehicles can be used to help manage risk within desired parameters and, hopefully, to enhance returns.
Modern Portfolio Theory
Modern portfolio theory suggests that a basic element in diversification of risk (with risk defined as the variation of actual returns around an expected return) is allocating the assets in an investment portfolio among categories of investments whose statistical performance correlations to each other are relatively low (or even with no correlation or negative correlation). Statistical correlations measure the extent to which the performance of various asset classes tends to move in the same direction as that of other asset classes (either up or down). A statistical correlation of 0 means there is no relationship in the performance of the two asset classes — they are independent of each other. A positive correlation indicates they tend to move in the same direction. A high positive correlation indicates they tend to move together more closely (to a higher degree), while a lower positive correlation means they tend to move together but to a lesser extent. A negative correlation indicates they tend to move in opposite directions. The statistical correlations are calculated from historical data on the performance (variability) of asset categories. Therefore, as with other historical statistical studies, the historical period used can be significant.
The essential idea is to manage or control portfolio risk (i.e., the variability of returns of the whole portfolio) by allocating the portfolio among uncorrelated asset classes or among asset classes with low correlations. That way, if one asset class, say common stocks, declines, another asset class, say high-yield bonds, may not decline, or may not decline to nearly the same degree, or may actually rise, depending on how correlated the asset classes are.
Thus according to modern portfolio theory, the addition of a higher-return asset class like high-yield bonds to a portfolio which consists, say, mainly of U.S. common stocks and high-grade U.S. bonds will not necessarily increase the overall portfolio risk if there is a low correlation between high-yield bonds and the other asset classes. In effect, this means that the addition of higher-return, more volatile asset classes to a portfolio will not necessarily increase the volatility (risk) of the portfolio as a whole, if the asset classes are uncorrelated or have low correlations.
Modern portfolio theory employs mathematical models to analyze expected returns, volatility, and correlations of individual asset classes. Many sophisticated techniques and investment vehicles can be used to help manage risk within desired parameters and, hopefully, to enhance returns.