When investing, risk and reward go hand in hand – that is, there are always associated risks when pursuing reward. That speaks to the core of what is known as Modern Portfolio Theory (MPT).
MPT, devised by Nobel economist Harry Markowitz in the early 1950s, is a financial model that assumes investors want to take a minimal level of market risk to capture favorable returns for a given portfolio of investments.
The theory is also referred to as mean-variance analysis, a mathematical foundation for constructing a portfolio of asset classes, such as stocks and bonds, to maximize the expected return for a given risk appetite. It’s a particularly useful investment approach for equity crowdfunding.
Instrumental in MPT’s logic is the assumption that most investors are risk-averse and will only consider riskier ventures if the potential payoff is substantial. Additionally, key to the theory is the argument that the risk of any given asset should not be examined in isolation, but rather by assessing its contribution to the broader portfolio’s risk and potential for return.
Think of it this way: Even if one asset class proves volatile in a given period, the portfolio as a whole, spread across multiple asset classes, can be low - and therefore a substantial source of reliable returns, Markowitz explains in his original paper introducing MPT.
Indeed, investment managers at times intentionally add higher risk assets into their portfolios in search of increased returns, knowing that potential losses could be made up by the range of other investments they hold, notably those that are relatively low risk.
For example, let’s say you invest in an early-stage company that sells surfboards in an island country. Some years, when the weather is good, surfboard sales are exceptional, and the company produces strong returns. But other years, when conditions are less favorable, sales may lag, making the risk associated with the investment and possible volatility relatively high.
However, if this investment only makes up a small percentage of your wider portfolio of investments, the risk is dramatically reduced. That’s MPT in action.
*Nothing in this article should be considered legal or investment advice. Startup investments are always inherently risky and following the advice in this article will not necessarily reduce that risk.