The Benefits of Modern Portfolio Theory
There is a secret to investing that many investors are never told: You can achieve higher returns and reduce your portfolio’s level of risk at the same time. Yes, you read that right, higher returns and lower risk are both possible.
This is not a magic formula designed by someone to sell you a get-rich-quick scheme. Rather, the creator of this strategy was awarded a Nobel Prize in economics.
In this article
- Modern Portfolio Theory
- The Efficient Market Frontier
- Putting Theory Into Action
- Other Considerations
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Modern Portfolio Theory
In 1952, Harry Markowitz wrote an essay titled “Portfolio Selection” that became the basis for modern portfolio theory). Modern portfolio theory holds that when various uncorrelated assets are combined in a portfolio, return is improved and risk is lowered. The risk level of the individual security does not matter as long as its return varies from the other securities in the portfolio.
When constructing a portfolio, you could opt for an extremely low-risk, but unsatisfactory long-term portfolio by holding only short-term government bonds. At the other extreme, you could create a long-term portfolio comprised of only high-growth stocks.
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