Portfolio Management For Risk-Averse Investors
Most of the things we spoke about earlier involve a certain amount of risk. But what about those investors who don’t want to take any risk?
Don’t worry, this has also been widely discussed and various theories have been formulated around these lines – the most popular being the "Modern Portfolio Theory".
Modern Portfolio Theory:
This theory talks about portfolio construction for a risk-averse investor to maximize expected return at a given level of market risk. It was pioneered by Harry Markowitz and first published in 1952. He was later awarded the Nobel Prize for this theory.
The basis of this theory is that an investment’s risk and return should not be viewed separately. Instead, it should be assessed based on the overall portfolio’s risk and return.
However, we know that risk and return are closely related when it comes to financial markets. Hence, if one opts for lower risk, he/she will obtain lower returns as well. On the other hand, riskier and more volatile investments fetch more returns. But not everyone is comfortable with such high amounts of risk.
This is where Modern Portfolio Theory suggests diversification. Hence, a portfolio may have one particular asset type which is a high risk, however, when combined with other asset types, the overall risk of the portfolio comes down. Thus, instead of holding only low-return bonds (less risky) or high-risk products such as derivatives or commodities, an investor can hold a mixture of both to earn maximum possible returns.
There are several benefits of this theory. It speaks about diversification. It also propagates reducing volatility. It works especially well if the assets in a portfolio are non-correlated. It is possible to create an efficient portfolio using this theory by choosing relatively low-risk options such as fixed deposits, Government of India bonds, etc.
However, since the formulation of theory, real-life market conditions have become much more complex. Therefore, the viability of the theory against the present-day market conditions remains a matter of doubt among portfolio managers and investors.