What exactly is “Modern Portfolio Theory?”

Who doesn’t want to have the perfect investment with high returns and low risk?  Unfortunately, that is a lot easier said than done—in fact, nearly impossible to achieve.  Great minds spend a lot of time developing theories and strategies designed to achieve the ultimate investment, but none has been more compelling—or more widely adopted—than Modern Portfolio Theory (MPT).

I could overwhelm you with statistical data, but instead, want to provide a brief background of MPT as well as its basic meaning.

Harry Markowitz developed MPT Theory in 1952, later receiving the Nobel Prize (along with William Sharpe and Merton Miller) for what has become a broad theory for portfolio selection.  Before Markowitz’s work became a guiding investment theory, investors focused on the risks and rewards of individual securities when putting together their portfolios, typically, building holdings of investor-identified securities which offered the best opportunity for gains with the least amount of risk (often railroad or utility companies).

MPT contends that it is not enough to look only at the expected risk and return of a particular stock. By investing in more than one stock, an investor can reap the benefits of diversification, lowering risk within a portfolio. Simply put this is the idea of not putting all your eggs in one basket.

Markowitz’s theory showed that wise investing is not just about selecting stocks, but about choosing the right combination of stocks designed to lower risk.  Within the entire universe of possible stock combinations within a portfolio, certain combinations will optimally balance risk and reward.  Markowitz called this ‘efficient frontier.’ This means that for every level of return, one portfolio offers the lowest possible risk and for every level of risk, one portfolio offers the highest return.  These combinations can be plotted on a graph and the resulting line would be Markowitz’s ‘efficient frontier.’

MPT states that the risk for an individual stock’s return has two parts:

§  Systematic risk = market risk that cannot be diversified, interest rates, wars, recession

§  Unsystematic risk = specific to individual stocks and can be ‘diversified away’ as an investor increases the number of stocks in his or her portfolio not correlated with general market movement.

Managing risk and return is a crucial part of developing an asset allocation strategy.  Proper investment planning requires a balanced approach with due consideration to short-and long-term liquidity needs, the blending of lower-and higher-risk approaches, and a combination of income and growth-oriented investments.

Our goal at Moneta Group is to identify our clients’ acceptable level of risk tolerance and then develop a portfolio that achieves the maximum expected return for that level of risk.  It is also important, when planning, to take into consideration the overall goals of each client. There is no one-size-fits-all portfolio, but MPT is a valid tool in helping our clients achieve their goals.

Karen Reese, MBA

Karen is the professional consultant for Nancy Georgen.

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