#todayinsight: Revisiting Risk: A New Perspective on Modern Portfolio Theory and Market Volatility

Harry Markowitz developed the modern portfolio theory in 1952. Later he won the Nobel prize for setting a unique and straightforward way to manage portfolios. The method is still used by all financial analysts. However, the implications of the model may not be understood well. One of the expectations of modern portfolio theory is that higher risk is akin to higher return. This has been a crucial law in the finance world. Risk on the other hand is usually measured by the volatility of the returns. According to the most common narration of modern portfolio theory, if a stock has bigger volatility, their average return should surpass a stock which is more stable.

However, Elroy Dismon and his colleagues has recently published a paper which challenges the definition of the risk and the way the modern portfolio theory is interpreted. They examined the price of American stock shares since 1963 and British ones since 1984. They ordered the shares based on the volatility and analyzed the returns.  For medium and low volatility, the returns are completely clustered with no meaningful correlation with the  volatility. 

For both countries, the riskiest stocks are the corporate minor with a market value of just 7 percent of the market. On the other hand, low risk companies are most likely giant ones which account for 41% to 58% of market prices.

Lower down the risk spectrum, it is surprising that still many people do not realize that low volatile stocks yield similar returns. Yet the modern portfolio theory should be reviewed, according to it each stock’s return is composed of an equation, Alpha that is its independent return factor, Beta through which it resonates with the market volatility and return. Alpha is hidden,if it was obvious, the stock price would adjust and drain out the alpha. Seeking alpha is one of the hardest tasks in the financial markets. It may be the case that stocks with low volatility and higher returns, have indeed low Betas and high Alphas. On the other hand, volatile and low return shares are the stocks with high Betas and negative Alphas. Neglecting Alpha for the stocks may result in poor portfolio returns.