Modern Portfolio Theory (MPT)
Chapters in this video
- 0:00 Why Adam the advisor needs MPT for Carl the risk-averse client
- 0:44 The correlation 1.0 exam trap and the diversification benefit scale
- 2:14 Unsystematic risk (company-specific) versus systematic risk (market-wide)
- 3:09 Business risk versus financial risk, and inflation risk as systematic
- 4:26 The efficient frontier: optimal versus suboptimal portfolios
- 5:15 The crisis flaw: correlations break when panic rises
- 6:06 MPT standard deviation versus CAPM beta: do not swap them
- 6:42 Rapid-fire exam recap
What this video covers
- Why a positive 1.0 correlation provides zero diversification benefit, and why negative 1.0 gives the maximum benefit
- How Modern Portfolio Theory (MPT) uses standard deviation (total risk) to build optimal portfolios, unlike the Capital Asset Pricing Model (CAPM) which prices individual assets using beta (systematic risk)
- Which named risks are systematic (market, interest rate, inflation, reinvestment) and cannot be diversified away
- Which named risks are unsystematic (business, financial, credit, legislative, regulatory, liquidity, political, currency) and can be reduced through diversification
- Why business risk (operations and sales failure) is not the same as financial risk (excessive debt leverage), even though both are unsystematic
- What the efficient frontier represents: the set of optimal portfolios offering the highest expected return for each level of risk, and why anything below it is suboptimal
- Why MPT's assumption of stable correlations breaks down in a crisis, when panic selling drives correlations toward positive 1.0
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