How To Understand Modern Portfolio Theory: Tips From Guillaume Jalenques de Labeau

As an established financial advisor and CEO for investment funds at PGC, Guillaume Jalenques de Labeau  understands the principles of Modern Portfolio Theory and applies these guidelines to …

As an established financial advisor and CEO for investment funds at PGC, Guillaume Jalenques de Labeau  understands the principles of Modern Portfolio Theory and applies these guidelines to his investment activities on behalf of clients in France, throughout Europe and from around the world. First released to the public in 1952 in the Journal of Finance, Modern Portfolio Theory (MPT) was created by Harry Markowitz and has been used since that time to identify the right mix of investments for a diversified and profitable portfolio.

Multiple Best Choices

Unlike tests that have only one answer for each question, MPT allows investors to explore a range of possible financial investments and combinations to identify the choices that offer the maximum expected return on investment. The array of portfolios that meet these criteria are known collectively as the efficient frontier in MPT and represent the most effective risk-reward balance for most investors.

Two Categories of Risk

MPT identifies and defines two types of risk in the investment industry:

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  • Systematic risk is not confined to any one investment or sector of the economy; instead, it refers to risks that affect the stock market and the economy as a whole. Recessions, depressions, interest rate fluctuations and market crashes are elements of systematic risk.
  • Specific risk refers to the potential for financial loss inherent in any investments made in the stock market or other financial venue. Diversifying portfolios can reduce the relative risk incurred by any specific investment or group of investments.

In most cases, little can be done to protect portfolios against systematic risks. Investing in government bonds or precious metals has often been touted as a hedge strategy. However, caution should be used due to the lack of liquidity and potential difficulties in divesting these investments from the portfolio when the economy recovers from its downturn.

Offsetting Risks

By incorporating opposing investments in the same portfolio, investors can often hedge their bets regarding major economic moves and market projections in specific industries or for certain industries. These are rarely one-to-one offsets, however, as these opposing investment strategies would essentially cancel out for no profit or loss. Instead, corporate entities and individual investors can offset part of the risk of an investment to soften the effects of an unexpected move in the marketplace.

Diversification

One of the most important principles of MPT is investment diversification. By incorporating a selection of short and long-term investments with varying risk profiles, private and corporate investors can often enjoy added protection against industry fluctuations and stock market corrections while achieving the highest possible return on investment for their portfolio.

Modern investment firms can provide valuable support in diversifying and offsetting risks to ensure optimal profitability. By working with a trusted financial advisor and applying the principles of MPT, private investors and corporate entities can ensure a solid balance between acceptable risk and potential reward in the modern investment marketplace.

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