Randomly spreading investments is better than not hedging at all. However, truly optimal investment decisions require a conscious selection of investments.
Does Modern Portfolio Theory Need an Extension to Include Private Markets?
The foundations of modern portfolio theory were developed by Harry Markowitz in the 1950s. With his mathematical and statistical method, portfolios in the public capital market were structured for the first time to offer the highest possible return for a given level of risk – or conversely, to minimize risk for a desired return. This theory remains the foundation of most modern investment strategies.
The Foundations of the Markowitz Theory
The core principle of portfolio theory is diversification, meaning the distribution of asset classes within a portfolio. Markowitz found that the individual risks of asset classes are not as decisive as their correlation with each other. By combining assets that do not correlate, the overall risk of the portfolio can be reduced without diminishing the expected return.
The optimization process is often illustrated using the so-called Efficient Frontier. This curve demonstrates which portfolios provide the optimal balance between risk and return. The ideal portfolio lies on this curve and is determined by the investor’s risk aversion.
Key Insights of Markowitz Portfolio Theory
- Overall Portfolio Risk: The risk of a diversified portfolio is generally lower – at most equal – to the weighted average risk of the individual assets included. This is because the price movements of different assets do not always run in parallel and can offset each other.
- Diversification as a Fundamental Principle: Concentrating on individual securities, asset classes, or geographical regions is almost always inefficient. Through diversification, risk can be significantly reduced while maintaining the same return.
- Correlation as the Key: The lower the correlation between assets, the better portfolio fluctuations can be balanced. Investors should actively seek investments that are independent or even move in opposite directions.
- Using Risks Strategically: Risky assets can, when added in moderate proportions, reduce the overall risk of a portfolio. The crucial factor is that these assets have a low correlation with the rest of the portfolio.
- Targeted Diversification: Randomly spreading investments is better than not hedging at all. However, truly optimal investment decisions require a conscious selection of investments that consider the correlation between individual components.
Modern Challenges and the Inclusion of Private Market Investments
Due to the increasing correlation between stocks and bonds in recent years, investors are increasingly considering private market investments. These can enhance return potential and contribute to portfolio diversification.
Private market investments have long played a crucial role in institutional portfolios. It is time for private investors to integrate them into their investment strategies as well. A growing number of research firms and portfolio analysts recommend evolving the traditional 60/40 allocation (60% equities, 40% bonds) into a mix of 50% equities, 30% bonds, and 20% private market investments.
The Markets Have Changed
The current environment—characterized by higher inflation, fluctuating interest rates, and sluggish growth—differs significantly from the conditions of the past 40 years. The BlackRock Investment Institute found that from 1980 until the end of 2021, investors could rely on a negative correlation between stocks and bonds, meaning they moved in opposite directions and thus provided sufficient portfolio diversification. However, in 2022, both asset classes moved in the same direction, causing investors to experience losses in both stocks and bonds. Private markets, on the other hand, delivered positive returns even in that year.
As a result, traditional asset classes like stocks and bonds are increasingly being complemented by private market products such as ELTIFs (European Long-Term Investment Funds), which invest in private equity, private debt, or infrastructure. However, allocations should vary depending on an investor’s risk tolerance. Additionally, the liquidity of investments must be considered, as each investor has different needs regarding how quickly they can access their invested capital.
Integration into a Markowitz-Based Portfolio
Incorporating private market products into portfolio theory requires adjustments to traditional models. Illiquid assets and the absence of public pricing data make it more difficult to precisely determine correlations and standard deviations. However, there are approaches to effectively integrating these products:
- Risk Management: The illiquid portion of a portfolio should align with the investor’s risk tolerance. A core-satellite strategy can be useful, where the core consists of liquid, well-diversified investments, while the satellite portion includes alternative investments.
- Modeling Returns and Risks: Historical data can be supplemented with simulation methods to better understand the potential performance of private market products. Typically, asset and fund managers provide insights into expected returns.
- Sustainability and Impact Investing: Many private market products—such as green infrastructure projects—support ESG goals and are well-suited for modern portfolios.
Building Better Portfolios
Markowitz’s modern portfolio theory remains an essential tool for financial and wealth advisors to determine the optimal balance between risk and return. However, the new market environment requires a broader and more dynamic investment approach.
By considering the entire portfolio and expanding beyond stocks and bonds, investors can benefit from private markets and make their portfolios more future-proof.