July 4, 2018

Modern Portfolio Theory

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Is there a formula to maximize returns and minimize risk? That's the idea behind Modern Portfolio Theory, the strategy of many robo-advisors today.

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Is MPT worth it? Does it really work? We discover the ins and outs of this theory below.

Dr. Harry Markowitz introduced Modern Portfolio Theory in 1952 in his doctoral thesis. He discovered the flaw in current strategies that did not account for risk and just focused on return. Markowitz then went on to write "Portfolio Selection," which sparked the interest in diversifying a portfolio.

The main premise behind his paper was to prove that a diversified portfolio is better than a portfolio chosen strictly on the investments with the highest return.

What Is Modern Portfolio Theory?

Modern Portfolio Theory focuses on the effect investments have on an entire portfolio, rather than as a single investment. In other words, choosing different types of investments will diversify your risk. Markowitz wanted to prove that looking at investments as a whole portfolio rather than individual investments will provide greater returns in the end.

Here's an example:

If you invest in three stocks individually, not focusing on how they affect your entire portfolio, you are at the mercy of the stock market alone. If stocks in general drop, you could face serious risk without anything to offset that risk.

If, instead, you diversify without putting all of your eggs in one basket, you may offset your risk. Let's say that instead of investing in just stocks, you put some of your money in bonds too. The bonds may offset the riskiness of the stocks. If stock prices drop, the bond prices may increase, helping to decrease the risk of a complete loss. This is a simplified example, but it shows you how choosing a variety of investments from different asset classes can offset your risk.

It's not a guaranteed protection against loss. Unfortunately, there's no foolproof way to ensure that you won't lose when you invest. No one can predict the future. Diversifying does help lower your risk, but it doesn't mean you won't experience loss no matter which investments you choose.

In short, Modern Portfolio theory maximizes your returns by minimizing your risk. The idea isn't to lower your expected return. Instead, it's to diversify your risk so that you can achieve your desired returns.

Understanding Risk and Return

Risk and return are the two main components of Modern Portfolio Theory. While they both may be obvious terms, they are worth mentioning.

Return: The profit you make on an investment is the return. It could be capital gains from stocks, dividends paid from companies you have ownership in, appreciation of an investment, or bond payments upon maturity.

Risk: This is the chance you take that a particular investment will not provide the desired return. In general, stocks have a higher risk level than bonds, but every investment carries some type of risk.

You can determine the return and risk based on the asset's history, but don't rely on it 100%. You should also take into consideration the market's condition and any predictions for the market's future.

Modern Portfolio Theory Assumptions

Modern Portfolio Theory assumes that investors see risk and return as directly related. You need to take a higher risk in order to receive higher returns. It is the hope of the theory, though, that diversifying will reduce the risk without reducing your returns. In other words, an investor should choose the portfolio with the lower risk without sacrificing the return.

Other assumptions MPT has include:

  • Investors are in the market to maximize returns
  • Investors don't take unnecessary risk
  • All investors understand the expected returns
  • Commissions are not included in the decision
  • All investors have the same information at their disposal

The Importance of Diversification

When you diversify your portfolio, you choose investments that aren't correlated. It could be as different as investing in stocks and bonds or as simple as choosing ETFs in different economic sectors.

If you choose investments within the same sector, you run the risk of them both reacting negatively to the same bad economic factors. Choosing investments in different industries and/or investment types diversifies that risk. In other words, the risk of these investments being affected by the same economic factors is very slim.

Criticism of Modern Portfolio Theory

No theory is without its faults or naysayers, and Modern Portfolio Theory is no exception. Some say that technical analysis offers better insight. Another common criticism is that the buy and hold philosophy that the Modern Portfolio Theory subscribes to isn't the best way to maximize returns.

Many investors believe that managing their own portfolio and actively trading is the best way to maximize returns. If you don't have the time or the knowledge to actively manage your portfolio though, the Modern Portfolio Theory may serve you well.

Bottom Line

So is the Modern Portfolio Theory something you should consider? If you invest with a robo-advisor, it will likely be the investment strategy used. Experts believe it's the best strategy to maximize returns while minimizing risk.

If you want a hands-off approach to investing that helps minimize risk, using a robo-advisor that utilizes Modern Portfolio Theory may be beneficial. As with any investment strategy, though, you should look at all of your options and choose the one that will help you meet your ultimate goal.

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