Modern Portfolio Theory

A key thesis of the Modern Portfolio Theory is the idea that investors frequently fail to consider the degree of “correlation” between different investments held in a portfolio.  Correlation is the degree to which the price of different investments move in the same direction.  When different investments move in the same direction a great deal of the time, there is a high degree of correlation.  When different investments do not move “in sync” with each other, there is a low degree of correlation.  Dr. Markowitz held the position that risk in a portfolio could be reduced and rates of return increased when there is a low degree of correlation between the investments held in a portfolio.

This potential benefit was initially put forward in 1952 by Professor Harry Markowitz of the University of Chicago.  He called his concept the Modern Portfolio Theory.  In 1990, Dr. Markowitz shared the Nobel Prize award for his work relating to the Modern Portfolio Theory.  For several decades, many institutional and sophisticated investors have used his concepts in the construction and management of their investment portfolios.  Regarding diversification, Dr. Markowitz concluded that it "reduces risk only when assets are combined whose prices move inversely, or at different times, in relation to each other."

The precise foundations of Modern Portfolio Theory are highly technical, based on statistical theory and probability.  It’s simply too complex for us to deal with here.  What’s most important is the simple conclusion that’s derived from Modern Portfolio Theory – a diversified portfolio that consists of uncorrelated assets has the best chance to provide favorable returns and reduce the volatility of returns within an investment portfolio.

Unfortunately, investors often believe they have diversified their portfolios if they hold some stocks, mutual funds, bonds, etc.  Although these investments are different, they remain in the same “class” of investments and they typically have a high degree of correlation (the price of each investment tends to move in concert with the others).  To gain the benefits defined by Modern Portfolio Theory, portfolios need to have different classes of assets whose prices move independently of each other.

Will A Hedge Fund Investment Give You The Proper Diversification?

As you consider whether a hedge fund investment would add diversification to your portfolio, it’s essential to examine the types of investments made by the fund.  If the hedge fund invests in stocks and bonds (perhaps in addition to other investments) then the degree of diversification the fund adds to your portfolio (assuming your portfolio has stock, bond and/or mutual fund investments) will be decreased. 

In order to gain the maximum diversification benefit from a hedge fund investment, the fund you select must invest in other, alternative types of investments.  Such investments would include a professionally managed trading program that trades derivative markets, real estate investments, etc.