Risk-reward relationship is one of the most important considerations for any investor. The core question: How much risk are you willing to take to get the return you need?
If you’re uncomfortable with a risky portfolio, it’s time to learn about Modern Portfolio Theory (MPT). Developed by Nobel-winning economist Harry Markowitz in the 1950s, it’s based on the idea that riskier assets, such as stocks, produce greater returns than less risky assets, such as government bonds.
But that doesn’t mean investors who tend to shy away from risk should just accept lower returns. A better approach, according to MPT, is to build an investment portfolio with a mix of assets that have varying risk levels. By doing so, you reap the benefits of higher returns without increasing your overall risk level.
Also known as mean-variance analysis, many investment managers use MPT as the model for creating efficient investment portfolios for their clients. Here’s what it’s all about.
What is Modern Portfolio Theory?
Modern Portfolio Theory is much more than a rubric for deciding whether to buy shares of Amazon or Netflix. It’s a model that helps investors create an optimal portfolio made up of several different assets (though that usually does include high-value stocks).
The key is to hold some assets that are negatively correlated, meaning they move in opposite directions in response to changes in the market. For example, when stock values are up, bonds are typically down, and vice versa. A portfolio consisting of a mix of stocks and bonds does more to minimize risk and maximize return than a portfolio of all bonds.
A concept called the efficient frontier is the foundation of Markowitz’s portfolio theory. Using historical data, the economist rated investment portfolios on a graph. Expected return was represented on the Y-axis and risk, measured by standard deviation, was represented on the X-axis.
The most efficient portfolios were the ones that provided the highest expected return for a given level of risk (the higher the standard deviation, the more risk).
The model suggested that when there are two portfolios with the same level of risk, investors should choose the one with a higher expected return. That assumes the goal is, essentially, to get the most bang for your buck.
The problem that individual investors face is a lack of time and resources to determine exactly what that efficient frontier looks like. However, we can infer that investing across multiple asset classes allows for a better return for a given level of risk than could be achieved with one asset class alone.
This insight brings us to the most important practical concept for managing your investments: diversification.
Modern Portfolio Theory & Diversification
Diversification has been called the only free lunch in investing. Relative to holding a single investment, diversifying across and within asset classes allows you to maintain the same level of return at a lower overall level of risk.
A broad group of investments that have, historically, exhibited similar levels of risk and return are an asset class. Examples of asset classes include equities (stocks), fixed income (bonds), cash, and “real” assets (physical assets like real estate and commodities). Certain asset classes are inherently riskier than others, and therefore have a higher expected return associated with them.
By its very nature, a diversified portfolio does not rely on a single asset to achieve its expected return. Instead, when one asset in the portfolio loses value, another one will likely make up for it by gaining value. As such, diversification tends to smooth out the bumps in the road, known as volatility.
Diversification isn’t an antidote to all risk. Investors still face systematic risk, which is inherent in all assets. This type of risk comes from things like interest rate changes and recessions — events that are out of an investor’s hands.
Applying Modern Portfolio Theory to Your Investments
Modern Portfolio Theory is subject to a number of limitations and imperfect assumptions. It should serve as a guide, not a directive.
At Personal Capital, our portfolio management team uses the MPT as a basis for investment strategies, but incorporates some adjustments for real life circumstances. With the Personal Capital Investment Checkup tool, you can see how well your portfolio uses risk and how it compares to a personalized, recommended asset allocation.
Returns are volatile in the short run over market cycles, but if you are investing with an eye towards retirement or long-term goals, your best bet is to diversify across asset classes.
The following are terms to know if you’re building an investment portfolio using Modern Portfolio Theory:
Strategic asset allocation: A core concept of MPT, asset allocation simply refers to dividing your investments among different asset classes, such as stocks and bonds.
Expected return: This is the expected profit or loss on any investment with historical rates of return. It is not guaranteed.
Standard deviation: This is a measurement of risk represented as a percentage. When comparing two investments, the one with a higher standard deviation is more volatile, and therefore riskier.
Portfolio frontier: To compare the efficiency of multiple portfolios, find the expected return and standard deviation of each portfolio. Then, chart the expected returns on the Y-axis and standard deviations on the X-axis. The upward sloping portion of the line is the most efficient portfolio.
Efficient frontier: Portfolios that offer the maximum expected return for a given level of risk are found on the efficient frontier.
Two-Fund Theorem: An investing strategy that uses only two mutual funds to achieve an appropriate level of diversification.
Capital Allocation Line (CAL): This is similar to the efficient frontier, but includes risk-free assets.
The Pros & Cons of MPT
Modern Portfolio Theory has both pros and cons. If it didn’t have downsides, there would be no use for alternative investing strategies because everyone would be cashing in on MPT.
Reduces investment risk through diversification. By investing in different assets that are not all positively correlated, you reduce the volatility of your investment portfolio — without decreasing your expected rate of return.
Eliminates market timing. Few investors find success buying and selling investments at exactly the right time. MPT eliminates the need to be a timing expert and instead employs a model that works independent of timing.
Assumes investors are rational. When markets are way up or down, investors can react impulsively and buy or sell to avoid short-term losses. MPT doesn’t factor investor behavior.
Based on standardized assumptions. The assumptions used to develop MPT have not been updated in decades. Some, like the idea that certain assets are always positively or negatively correlated, may be disproven in changing market conditions.
Overlooks fundamental analysis. In considering only the risk and return of an investment, MPT does not factor in its intrinsic value.
Modern Portfolio Theory is an investing tool that may not be right for everyone. While it’s based on extensive research and analysis, it is subject to limitations and imperfect assumptions. It was developed 70 years ago and doesn’t account for the ways in which 21st century capital markets have changed.
Still, MPT provides a solid foundation for understanding the importance of risk and return in your investment portfolio. The model reassures many risk-averse investors that the risk level of individual assets will not make or break their portfolio’s performance. Instead, multiple carefully chosen assets can work in harmony to maximize expected return.
Want a better way to manage your investments? Millions of people use Personal Capital’s free and secure online financial tools to see all of their accounts in one place, analyze their investments, and plan for long-term goals, like buying a house or saving for retirement.
Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.