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Here's what you need to know about modern portfolio theory.

Modern portfolio theory (MPT) focuses on how to maximize returns for a given amount of risk. However, it also attempts to strike the balance between risk and reward to keep those returns steady. By encouraging investors to diversify their portfolio and rebalance it when necessary, MPT attempts to help investors find the right risk-reward ration. Here’s how it works.

Modern Portfolio Theory at a Glance

Modern portfolio theory back to the 1950s and is one of the most important theories of investment management. It proposes that an investment’s risk and return characteristics should be weighed by how they affect an overall portfolio.

MPT does not just seek to pick single investments promising the most reward with the least risk. Instead, MPT encourages investors to build a portfolio that considers the overall risk and reward of all investments.

Ideally, an investor can build a portfolio with assets that provide maximum returns for a specific risk tolerance. Meanwhile, if an investor expects a certain return, they can build a portfolio that may yield that return with minimal risk. The return on any one asset is less important than how it contributes to the larger portfolio.

The basic idea is that mingling assets with different risk and reward potential creates a less risky, more productive portfolio. MPT assumes that it is difficult to beat the market without taking on additional risk. However, it promises investment managers a way to maximize return while limiting risk.

Keys to Modern Portfolio Theory

Here's what you need to know about modern portfolio theory.

MPT assumes that in order to get more reward, investors must take more risk. Meanwhile, it suggests that investors will only take on added risk if there’s additional reward waiting for them.

Safe investments like U.S. treasuries may offer less reward than buying shares in biotech startups. Biotech startups offer greater potential rewards, at the risk of losing everything if the startup goes under.

MPT also emphasizes diversification of your portfolio. It notes that combining investments with different risk-reward profiles maximizes a portfolio’s reward while minimizing risk.

Diversification works because investments aren’t perfectly correlated. For example, when stock values fall, bond values tend to be more stable. As a result, mixing stocks and bonds in a portfolio can ensure adequate rewards from stocks. It also protects bonds against downside risk.

Risk is measured by an investment’s variance, on the amount an investment’s return can swing from its usual state. Stocks, for instance, are generally more variable and so more risky than bonds.

Modern Portfolio Theory for Investors

MPT accounts for investors with different appetites for return and different tolerance for risk. Advisors often ask investors how big a drop in portfolio value they would be comfortable with. Any advisor may also ask about the investor’s desired rate of return or ultimate objectives.

Using the information about the investor’s tolerance and goals, MPT helps construct a portfolio with the appropriate amount of variance and return.

Through asset allocation, a portfolio is given the right mix of stocks and bonds for a specific risk tolerance. Stock investments may be further diversified by choosing shares of companies of different sizes. Bond holdings may be tailored to include securities of different ratings. Other asset classes including real estate and commodities may be added for more diversification.

The result should be a portfolio with an ideal risk-reward ratio. A portfolio maximizing risk and reward is said to lie along the “efficient frontier.” This refers to a line on a graph plotting risk versus reward. A portfolio on the efficient frontier will, according to the theory, provide maximum return for the desired level of risk. MPT notes that a stock portfolio on the efficient frontier should be balanced out by low-risk assets like treasuries.

That makes rebalancing a key portion of MPT. Rebalancing involves buying and selling investments to maintain the desired mix of assets in a portfolio. For instance, some portfolios have 60% in stocks and 40% in bonds. Occasionally it may be necessary to sell stocks and buy bonds, or vice versa, due to changes in the markets. This will help keep the desired balance.

Limits of Modern Portfolio Theory

Here's what you need to know about modern portfolio theory.

The math behind modern portfolio theory can be daunting. However, investment companies offer mutual funds that do the work for investors, including rebalancing as necessary. Funds marketed as “aggressive,” “conservative” or “balanced” often use MPT to craft portfolios suiting different types of investors.

Keep in mind that MPT is still a theory, and relies on the idea that the future will be like the past. When looking at returns and variances, the theory uses historical data to reach its predicted returns. As every investment advertisement concedes, past performance is no guarantee of future performance.

Economics Harry Markowitz introduced MPT in 1952. He later earned a Nobel Prize in economics for his contribution. In the 1960s, another Nobel Prize went to Eugene Fama, whose research added to the theory’s underpinnings.

Markowitz says he didn’t necessarily follow MPT himself. In his younger days, he didn’t bother with complicated calculations of variance and correlations. Instead he simply split his personal portfolio 50-50 between stocks and bonds.

Bottom Line

Modern portfolio theory has good intentions and aims to create the most return for investors while honoring their risk tolerance. However, in recent years, it has coupled with the ideas of behavioral finance. Touted by investment analysts including Ken Fisher, behavioral finance adds concerns such as investor psychology to the statistical foundations of MPT.

Despite its age and limitations, MPT is still highly influential among investment managers. If you’re building or maintaining a portfolio, there’s a chance that MPT will still factor into your plans.

Investing Tips

  • You don’t have to determine your ideal risk and reward on your own. A financial advisor can help. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Don’t know what assets are right for your portfolio or what level of risk you’re comfortable with. SmartAsset’s investing guide can give you some clues about where to start, how to rebalance, and how external forces like inflation and capital gains tax affect your investment.

Photo credit: ©iStock.com/rfranca, ©iStock.com/martin-dm, ©iStock.com/Tinnakorn Jorruang

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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