From Theory to Practice: How to Apply MPT Concepts to Your 401(k) Plan

Modern Portfolio Theory. It sounds highly academic and esoteric. But in fact Modern Portfolio Theory—commonly referred to as simply MPT—is the accepted approach to investment and portfolio management today.

Fortunately, you don't need a Ph.D. in investment theory to benefit from the implications of MPT. In fact, the general concepts can guide you in better managing your own 401(k) portfolio. Just what is MPT?

There are two major parts to MPT:

• The first part is centered around the idea that the best combination of assets—your investment portfolio—should be developed by focusing on how the various components perform relative to each other.
  
  
• The second part is centered around the idea that the natural outcome of many people searching for underpriced securities in the markets should be an "efficient market" in which it is difficult to add value by finding underpriced securities, particularly since it is expensive to do so. This implies that, instead of trying to find undervalued securities, investors should buy and hold "the market" to receive the market's return with minimal costs. This theory gave rise to index funds, which today have become extremely popular among investors. How can you manage your 401(k) plan using these concepts?

The following four steps can guide you in carrying out an investment management process that is consistent with the tenets of the Modern Portfolio Theory (MPT).

1) Determine Your Risk/Return Preference

Some people mistakenly think that MPT suggests that they should buy and hold a low-cost stock index fund. It does not. Rather, it says that each investor should first determine his or her target asset allocation.

Although future returns are unknown, portfolios composed of a mix of stocks and bonds will offer a better risk/return trade-off than portfolios composed primarily of bonds.

The amount you commit to stocks is a function of how much risk you can tolerate. The ability to keep your stock portion invested in the stock market during the 2000-2002 bear market may help you determine your ability to bear stock market risk.

2) Form a Diversified Portfolio

The first part of this step is to select the asset classes in which you wish to invest.

Which should you include? Model portfolios recommended by investment professionals suggest that the major asset classes are U.S. stocks, international stocks, and U.S. high-grade bonds (including cash). Furthermore, with the possible exception of portfolios for retirees, model portfolios consistently recommended that international stocks should consist of between 15% and 30% of the stock portfolio.

Notably, no model portfolios recommend allocations to hedge funds or international bonds.

The second step in forming a diversified portfolio is to determine your target allocation for each asset class. This target allocation can be limited to the three major asset classes. For example, it may be 45% U.S. stocks, 15% international stocks, and 40% high-grade bonds.

Alternatively, some individuals prefer to separate U.S. stocks into smaller sub-asset classes like large-cap growth, large-cap value, and small-cap stocks. However, MPT and history suggest that the U.S. stock portfolio should be broadly diversified across size (large-cap through small-cap) and styles (value and growth stocks). Similarly, international stocks should contain stocks in developed markets across Western Europe, Japan, and Australia.

3) Select Mutual Funds

Although individuals can invest in individual securities or mutual funds, the latter is usually the only option in a 401(k) plan, so it will be emphasized here.

One prudent strategy is to invest your entire U.S. stock portion in an index fund, or a low-cost active fund that benchmarks a total stock market index fund like the Russell 3000 or Dow Jones Wilshire 5000 index.

Another prudent strategy would be to invest in separate index funds to create a portfolio tilt toward smaller or larger stocks. Small tilts away from a size-neutral or style-neutral allocation are examples of tactical asset allocation, and are not considered imprudent.

International diversification can be achieved by investing in an index fund or active fund that benchmarks a total international stock index of the developed markets.

The U.S. bond market can be separated into investment-grade or better (high-grade) and low-grade bonds. The Lehman Brothers aggregate index represents the high-grade bond market. One prudent strategy would be to invest in an index fund, or low-cost active fund that benchmarks this or a similar index. In short, it is not difficult to attain a well-diversified prudent portfolio. And once you have attained a well-diversified portfolio, you should stick to it, which brings us to the last step.

4) Rebalance Periodically

MPT would suggest that investors rebalance their portfolios periodically. The purpose of rebalancing is to allow you to maintain a stable risk exposure. For example, if your target asset allocation is 45% U.S. stocks, 15% international stocks, and 40% U.S. bonds then, unless something happens to cause you to change your target asset allocation, you should rebalance back to these weights periodically.

At what point is your portfolio considered out of balance? One general rule would be to rebalance whenever the actual asset allocation to a broad asset class varies at least 10% from the target allocation. For example, if your target allocation is 40% bonds and your bond allocation varies outside the 30% to 50% range, then rebalancing is in order. For narrower asset classes like international stocks, the range may be plus or minus 5%.

Rebalancing can be done by shifting funds from one fund to another. Another approach to rebalancing is to allocate new investment funds to the underweight asset class.

In addition, as you age, your target asset allocation may slowly become more conservative. If so, then you should rebalance your portfolio back to the slowly changing target allocations.