Modern Portfolio Theory
Is there a formula to maximize investment returns and minimize risk? That's the idea behind Modern Portfolio Theory, the strategy of many robo-advisors today. Read on to learn more.
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Dr. Harry Markowitz introduced Modern Portfolio Theory or MPT in his doctoral thesis in 1952. He discovered that current strategies just focused on return but did not account for risk.
Markowitz went on to write "Portfolio Selection," which sparked the interest in diversifying a portfolio.
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.
Diversifying does help lower your risk, but it doesn't mean you won't experience loss no matter which investments you choose.
Consider this example: You invest in three stocks individually, not focusing on how they affect your entire portfolio. This means 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.
But 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 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.
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: 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.
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.
The theory suggests, 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. They 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 flaws and naysayers. Modern Portfolio Theory is no exception.
Some say that technical analysis offers better insight. Others believe the buy and hold philosophy that MPT 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.
Bottom Line
Is 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.
Write to Kim P at feedback@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.
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