How To Use Modern Portfolio Theory To Maximize Your Investment Returns

Posted on Nov 28, 2022 at 05:11 PM

In today's world, applying the principle of modern portfolio theory to the work system adopted within companies and investment institutions has become an essential and indispensable matter.

Although there is no perfect investment in our current world, it becomes possible for the investor to apply modern portfolio theory. This theory provides additional financial returns and reduces some of the potential risks.

It is worth noting that the economist (Markowitz) is the one who designed this theory. This theory aims to represent a tool that balances the element of return and risk or expected loss within any investment model.

Given the importance of applying the principle of these portfolios to all types of investments, investors need to be fully aware of the initial asset Management Process of those portfolios and the roadmap that leads to a successful investment, whether in terms of economic return or the number of potential risks. This is what we will discuss in our article for today.

What Is Modern Portfolio Theory?

Initially, Harry Markowitz created the idea for this theory in his article "Portfolio Selection". From this point on, the theory became popular among investors as one of the essential theories contrary to the traditional investor mentality.

The principle of Modern Portfolio Theory (MPT) is based on the fact that there is a close relationship between both the return and the risk of an investment. This means that there is no more financial return on the investment without an expected risk.

But the main objective of the investment portfolio theory remains that investments are exposed to only a tiny level of risks while achieving a level of economic returns that match the desired goals of the investors.

Not only that, modern portfolio theory relies on a set of concepts it believes investors should understand to promote their investments to the level of successful acquisitions.

Relationship between risk and return on investment:

Markowitz's general principle when he created modern portfolio theory was that no type of investment is not exposed to a certain level of risk. This is whether the risks of economic fluctuations within Types of Financial Markets, the inflation of expenditures, and other threats lead to the loss of capital or the failure to achieve the desired economic return.

In short, there is no guaranteed overall return or investments that are entirely safe from risk. However, investments can be analysed and classified using asset classes or according to their threats. For example, stocks are considered high-risk investments, certificates of deposit are medium-risk, etc.

An ideal portfolio guarantees the investor that the risk remains within the expected level. Or, the perfect portfolio can achieve the contrast between increasing the Return on Investment (ROI) and reducing the risk. You can achieve this level of investment by allocating a specific area of diversification.

What is the role of diversification in developing the ideal portfolio?

Managing a single investment to make it ideal is a far-fetched method, especially since you will not be able to reduce the risks within only one level of assets, according to what we discussed previously regarding classifications and divisions.

Therefore, it is necessary to implement the idea of diversifying the modern financial portfolio of your investments in an innovative and controlled manner so that it contains high-risk, medium-risk, and low-risk investments. All this is to achieve an ideal investment in terms of economic return, amount of risks and their impact.

For example, to better explain the ideal portfolio in question, let's say that by investing many stocks and certificates of deposits simultaneously, you will ensure greater economic returns and achieve a moderate or somewhat acceptable level of risk.

What is the role of effective boundaries in modern portfolio theory and investment analysis?

Modern portfolio theory requires investors to reach an Efficient Frontier on investments within the portfolio. Therefore, the combination of these investments is called the influential group.

This group is a group of portfolios that offer either the highest expected return on investment or risk within a limited level. Or a lower level of trouble with the lower performance of the company's financial and economic returns.

The other portfolios that provide less efficiency than the previous groups, i.e. below the practical limit, are called the sub-optimal group.

That is, the investors are expected to create an investment portfolio that includes one of the mentioned adequate limits to achieve the desired goal of modern portfolio theory.

Finally,

We have provided a summary to give information on the first key features of Modern Portfolio Theory. Despite this, more is needed, as its content is significant. Moreover, specialists in this field must communicate the practical methods necessary to create a successful investment portfolio management subject to modern portfolio theory principles.

There are also many standard statistics aimed at helping investors to get a general idea of the risks of their investments. Such as the standard deviation index, the alpha index, the beta index, the R Squared index and the Sharpe ratio index. These indexes should not be mentioned in a few lines because the reader's mind will need to comprehend them in this way.

Final Thought, if you want to achieve high investment returns and are planning successful investments, we advise you to attend an Investment Management Training Course in Paris.