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The Benefits of Modern Portfolio Theory

by Charles Rotblut, CFA

The Benefits Of Modern Portfolio Theory Splash image

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.

Modern Portfolio Theory

In 1952, Harry Markowitz wrote an essay titled “Portfolio Selection” that became the basis for modern portfolio theory (MPT). 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.

Between these two extremes are portfolios that contain just the right mix of assets. In other words, you want a portfolio with assets and securities that complement each other.

The Efficient Market Frontier

Markowitz formulated that there is a line at which a portfolio produces the ideal amount of return for a given level of risk: This is known as the efficient market frontier. It shows whether a portfolio is taking on too much risk for a given a level of return. It can also reveal whether or not a portfolio is achieving a high enough return for the amount of risk it is taking.

As you can see in Figure 1, the efficient market frontier is curved. The reason is that there is a point of diminishing performance relative to risk. After a certain point, the amount of additional return diminishes as the level of risk is increased (upper, right-hand end of the line). Similarly, a portfolio that is too conservative does not even generate enough return to compensate for its inherent low risk (lower, left-hand end of the line).

Putting Theory Into Action

The goal for investors is to build a portfolio out of uncorrelated assets and securities—this holds true regardless of your risk tolerance. I will give you two examples.

First, investors who are risk-averse will want to allocate the majority of their portfolios to bonds or bond mutual funds. The types of bonds included in the portfolio should have differing maturity dates, varying issuers (Treasury, municipal, corporate, international, etc.) and various credit ratings. A smaller portion of the portfolio should be allocated to other asset classes (e.g., stocks) to provide protection against inflation and periods of rising interest rates.

Second, investors with a higher tolerance for risk will want to allocate the majority of their portfolios to stocks. The equity portion should mix various sectors and industries, styles (growth and value), market capitalizations (small, mid and large), and geographic regions (domestic, Europe, Asia and Latin America). A smaller portion of the portfolio should be allocated to other asset classes (e.g., bonds) to provide protection against bear markets as well as a stream of income.

In both examples, the idea is to lower the risk by combining several different types of securities. This moves the portfolio closer to the efficient market frontier by enabling it to benefit from several market forces instead of just one or two.

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Other Considerations

The examples above used stocks and bonds. A truly diversified portfolio should include other asset classes as well, such as real estate and commodities. In both cases, owning the physical asset (e.g., actual land or bullion) provides more diversification than a real estate investment trust (REIT) or mining company. (However, a REIT or shares of a mining company would be easier to buy and sell.)

During times of financial distress, correlations of different asset classes can move toward 1.0, meaning they move in the same direction. This occurred during the bear market of 2007–2009. But even when all classes become seemingly correlated, the actual level of loss will differ from the decline that would have been experienced if the portfolio were invested in a single asset class.

Other articles in the Beginning Investor series:

How to Start,” April 2010

The Basics of Portfolio Allocation,” May 2010

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


Discussion

Joe from NC posted over 4 years ago:

Am I the only one NOT getting the chart? All I get is a black line.


Joe from NC posted over 4 years ago:

Am I the only one NOT getting the chart? All I get is a black line.


Joe from NC posted over 4 years ago:

Am I the only one NOT getting the chart? All I get is a black line.


Lee from FL posted over 4 years ago:

Me,too. I get the same black block that instructs me to click on it to see entire chart. No luck


Shawn from CA posted over 4 years ago:

Hi Joe
I don't get the link either but if you click the

http://www.aaii.com/journal/article/the-benefits-of-modern-portfolio-theory.pdf

or printer

http://www.aaii.com/journal/article/the-benefits-of-modern-portfolio-theory.mobile

links top left above you can see the graph.

:-)


Britni from CA posted over 4 years ago:

oops...not the printer link--just the pdf link:

http://www.aaii.com/journal/article/the-benefits-of-modern-portfolio-theory.pdf
:-)


Praveen from OH posted over 3 years ago:

The problem with this theory is that it equates volatility (SD) with risk. If this basic premise is incorrect, then the whole "efficient market frontier" theory fall apart.


Jan from SVK posted over 3 years ago:

I agree with Praveen.
Let's consider this idea. MPT is based on so-called "buy and hold" strategy, where risk (volatility) is inevitable part of every given financial instrument and this risk is tied to the given expected return on investment. What if there is a theory that focuses on actively managing both sides of every investment: return and risk. By managing (via active trading or speculative investing), you can separate these two sides of every coin and deal with them through diferent risk management and trading tools. You can definitelly get better results...


Faye from IN posted over 2 years ago:

Has your theory been put to the test? Is a Noble Prize in your future? Jan from Illinois and Praveen from Ohio.


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