Modern Portfolio Theory: Investor Fundamentals

Tuesday 20 April 2004

This is the first in a series of informative articles on the basic principles of modern portfolio theory. Modern portfolio theory encapsulates the many assumptions made in investments including the long term horizon of investment, diversification, expected return, volatility and risk. In this article we introduce some of these basic principles.

By The Landlord

In modern portfolio theory, statistical measures are used to describe investment characteristics of differing asset classes. The two primary measures are expected volatility and expected return. Modern portfolio theory essentially uses the fluctuations in expected return to determine the expected volatility of an investment.

Expected return is simply the performance of an investment that you are likely to receive over a long time horizon. It is calculated using the range of possible returns adjusted for the probability of each occurring. For example, over a two-year period, you may expect equities to return 12 per cent in the first year and 6 per cent in the second. Therefore the expected return, or average return, is 9 per cent (12+6/2=9). Although equity returns may fluctuate from 25 per cent to -25 per cent over the long term, you would still expect that your return to revert to the expected return.

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