subject: Modern Portfolio Theory [print this page] Modern Portfolio Theory Modern Portfolio Theory
Modern Portfolio Theory
There are two explanations which preserve the integrity of earlierand more theoretical discussions of risk and return. First, as was explained in the last article, according to modern portfolio theory, therisk premium of an individual asset is not measured by its own variability considered in isolation but rather by the contribution which itmakes to the variability or riskiness of a diversified portfolio to whichit is added. An individual stock with very great variability would beexpected to have a rate of return not much greater than that of bondsof high quality if the returns on the stock were not highly correlatedwith returns on the market as a whole and it therefore did notadd much to the riskiness of a diversified portfolio. In fact, a common stock whose returns were not correlated at all with returns on themarket would be expected to have returns equal to those on a risklessasset.
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It is plausible to assert that stocks of the lowest quality or withthe greatest historic variability have returns which are less highly correlated with the market than stocks of higher quality and less historicvariability. The stocks of the highest quality are often stocks of verylarge and widely diversified corporationsstocks such as AmericanTelephone, General Electric, General Foods, Standard Oil Company(New Jersey) and so on. These great corporations are often deemedto be "blue chips" or of "investment grade," the implication beingthat they are of high quality and have rates of return which can bepredicted with greater confidence than can those of stocks of lesserquality. Since each of these corporations is very large, and since theprofitability of each depends upon levels of demand in almost all partsof the country and in many different industries, it is not surprisingthat rates of return on these stocks are highly correlated with movements in the general economy and in the market as a whole.
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By contrast, stocks of the lowest quality or with the greatest variability are often stocks of relatively small and immature companies whoseprofitability depends to a greater degree upon things other than thegreat tides in the movement of the general economy and the general market. It is easy to think of exceptions, but the generalization seemsvalid. If that is so, the stocks of lowest quality and with greatest historicvariability may well have returns that are not highly correlated withthe market and which consequently do not contribute as much tothe riskiness of diversified portfolios as might be surmised on the basisof their total variability. This explanation amounts to saying that historic variability does not determine the risk premium of an individualasset, and that the deficiency in the measure has important consequences for the stocks with the greatest variability.
