Traditional vs. Modern Portfolio Theory (MPT) ⚖️🥊
In the previous chapters, we explored both the Traditional and Modern approaches to building a portfolio. To master Portfolio Management, you must understand how they differ in their philosophy, risk management, and overall goals.
1. Philosophical Difference
The biggest difference lies in the unit of focus.
- Traditional Approach: Believes that if you pick enough "good" stocks, you will automatically have a good portfolio. It focuses on individual security selection.
- Modern Approach (MPT): Believes that a "good" stock might be "bad" for your specific portfolio if it behaves exactly like your other stocks. It focuses on the portfolio as a single unit.
2. Risk Management
How do they handle the "danger" of losing money?
- Traditional: Uses "Simple Diversification." This means buying 15-20 stocks from different sectors (Banking, IT, Steel). It relies on qualitative judgment.
- Modern: Uses "Mathematical Diversification." It calculates the Correlation between stocks. It aims to combine assets that have negative or low correlation to cancel out risk.
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4. Which one is better?
It's not that one is "wrong" and the other is "right." Most professional wealth managers today use a Combination approach:
- They use Traditional Analysis (Fundamental analysis) to find high-quality companies with strong earnings.
- They use Modern Theory (Optimization models) to decide exactly what percentage of each stock to hold to minimize risk.
Summary
- The Traditional approach is qualitative and stock-focused.
- The Modern approach is quantitative and portfolio-focused.
- Traditionalists believe in "Quality"; Modernists believe in "Correlation."
- Modern finance is built on MPT, but it still uses traditional principles to select the assets for the model.
Quiz Time! 🎯
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