Overview
Modern portfolio theory is a framework for constructing investment portfolios to maximize expected return for a given level of market risk, or equivalently, to minimize risk for a given level of expected return. Developed by Harry Markowitz, this theory posits that investors are risk-averse and will choose portfolios that offer the highest possible return for their desired level of risk. It emphasizes diversification as a key strategy to achieve optimal portfolio performance.
The core principle involves combining assets that do not move in perfect lockstep, thereby reducing overall portfolio volatility. By understanding the relationships between different assets, investors can build a portfolio that is more resilient to market fluctuations.
- Core Principle: Modern portfolio theory (MPT) focuses on the idea that the risk of an individual asset is less important than its contribution to the overall portfolio’s risk.
- Diversification Strategy: It advocates for combining various assets with different risk-return characteristics to reduce overall portfolio risk without sacrificing expected returns, a concept further explored in optimizing investments.
- Efficient Frontier: MPT introduces the “efficient frontier,” which is a set of optimal portfolios that offer the highest expected return for a defined level of risk.
- Risk-Return Trade-off: Investors can use MPT to identify their ideal balance between risk tolerance and desired returns, helping them make informed investment decisions.
Modern Portfolio Theory: Optimize Your Investments With KWB
Our best technique for protecting portfolios is called Modern Portfolio Theory.
This Nobel Prize winning idea said it is insufficient to look at investments in isolation as is done in the traditional approach of picking stocks and bonds. Rather rational investors will seek out “efficiently diversified portfolios” offering the highest expected return for each level of risk.
In the graph below, portfolios A, B, and C are all efficient portfolios ranging from safer A to riskier C. Portfolio D is an inefficient portfolio. A successful investor would never choose portfolio D because portfolio A has the same expected return, but much less expected risk. Similarly, while portfolio C has the same risk as D, it also has a much higher expected return.
For investors who have accumulated a portfolio of investments, a few investments each year, year after year, how likely is it that they achieve an efficiently diversified portfolio providing the highest return for each level of risk, like portfolios A, B or C? Or is it likely that their “collection of investments” takes too much risk or receives too little return like portfolio D?
Modern Portfolio Theory has two simple objectives for each investor to keep in mind when building their diversified portfolio. The first is that your portfolio must be invested in a manner that captures the full market return of each asset class represented in the portfolio. MPT makes no requirement to outperform the market return, however, you can’t underperform either.
Second, you should choose securities that take market risk (not diversifiable) and eliminate non-market risk, which is diversifiable (as discussed in the previous article Investment Risk).
A simple and modern way to achieve the objectives of MPT in your portfolio is to choose asset class securities called index funds, asset class funds or exchange-traded funds. These are easily combined into efficiently diversified portfolios. Each of these types of securities is designed to earn the market return, protect against underperformance and do so by eliminating unnecessary risk.
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Thanks to Chris Turnbull of The Index House for providing this article.
The Index House is a division of Polaris Financial Inc.