10. What is MPT?
Modern Portfolio Theory (MPT) is the basic approach to investing that is taught in the leading business schools. MPT is used or MPT tools are considered by many investment professionals. MPT results from decades of computer-based analysis of historic performance. This analysis has produced many investment insights and several Nobel prizes. Two main MPT insights are:
- Market / Group Performance – the performance of a stock is influenced by the movement of the entire market and also by the group to which the stock belongs. Researchers discovered group correlations by using large computers programmed with sophisticated formulas to process huge amounts of historic stock price data. For example, Dimensional Fund Advisors (DFA, a leading passive investment manager) found that small cap stocks have outperformed large cap stocks by several percent and value stocks have outperformed growth stocks by several percent.
- Portfolio Statistics – they include:
- Historic Returns – compare past returns to other portfolios and to benchmarks;
- Volatility – compare volatility using standard deviation relative to the benchmark and beta, another measure of volatility; short-term volatility is the most widely used measure of risk;
- Sharpe Ratio – compare the amount of added return for each unit of added risk; and
- Alpha – compare stock picking ability, since higher alpha portfolios tend to rise independent of stock market factors.
Morningstar is best known for its mutual fund ratings, but its Snapshot service facilitates comparing and monitoring the MPT characteristics of a securities portfolio.
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