If you’re an investor, then you owe a word of gratitude to the late Nobel Prize laureate Harry Markowitz and his work on Modern Portfolio Theory (MPT). The development and subsequent implementation of MPT in the investing world over the last century have brought about fundamental changes in how investors approach the construction and management of portfolios.
“Most of the widely used professionally managed portfolios you will find today build on the concepts from MPT,” says Todd Schlanger, senior investment strategist at Vanguard. “For example, the often-cited ’60/40′ portfolio that invests 60% in equities and 40% in fixed income in an attempt to maximize the risk and return trade-off can trace its origins back to MPT.”
Introduced to the world in his 1952 paper “Portfolio Selection,” published in The Journal of Finance, Markowitz’s ingenious idea was to concentrate not on the risk and return of individual securities, but rather on how each one interacts with the other securities in the portfolio.
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Essentially, MPT guides investors on how to construct more “efficient” portfolios, or portfolios that can provide the maximum expected returns for a specific level of risk, or the lowest level of risk for a target return expectation.
“Investors should aim for an optimal level of risk that aligns with their financial goals, and MPT helps identify portfolios that offer the best trade-off between risk and return,” says Wes Moss, managing partner and chief investment strategist at Capital Investment Advisors.
MPT is now considered indispensable knowledge for anyone aiming to optimize the balance of risk and reward within their portfolio. Its principles have stood the test of time and continue to inform the strategies and decision-making processes of investors, retail and professional alike, around the world.
Here’s all you need to know about MPT, its principles and how you can apply MPT to your investment strategy:
— Correlation and volatility.
— The efficient frontier.
— Applying MPT to your portfolio.
Correlation and Volatility
At the core of Modern Portfolio Theory lies the concept of diversification. For most investors, this principle resonates intuitively – by spreading investments across stocks from diverse sectors, geographies and styles, one can mitigate the risk of poor performance in one or a few specific assets.
However, MPT goes a step further. “MPT suggests that investors should diversify away uncompensated risks in the portfolio by combining multiple uncorrelated, volatile asset classes in an optimal way that maximizes expected returns relative to a given level of risk,” Schlanger says.
To fully understand how MPT views diversification and how it plays a role in optimizing risks and returns, investors must first grasp two interrelated concepts: correlation and volatility.
Correlation, in the context of MPT, refers to the degree to which the returns of two different investments move in relation to each other. If two assets consistently move in the same direction, they are said to have a high positive correlation. Conversely, if they often move in opposite directions, they have a high negative correlation. A zero correlation implies no consistent relationship between the movements of the two assets.
Volatility, the second concept, is a measure of the price fluctuations of an asset or portfolio. It represents the degree of variation of a trading price series over time. High volatility often means higher risk, as the asset price can change dramatically over a short period in either direction. That being said, high volatility is not necessarily a negative in the context of MPT.
“The key insight of MPT is how to reconsider risk, as previously one looked at the risk of an asset in isolation,” says Robert Johnson, professor of finance at Creighton University’s Heider College of Business. “Thus, a stock with a wide dispersion of returns, or high volatility, would be considered riskier than a stock with a tighter dispersion of returns, or low volatility.”
MPT changed this, and now risk is evaluated based on the contributions of an asset to the overall portfolio in terms of both correlation and volatility.
Understanding the interplay of correlation and volatility is essential to the process of diversification. By combining high-volatility assets with low or negative correlations, an investor can actually reduce the portfolio’s overall risk. Simply put, when one asset in the portfolio is performing poorly, another asset may be performing well, thus offsetting the losses and smoothing out returns.
[READ: How to Invest in Stocks for Beginners]
The Efficient Frontier
Perhaps the most influential contribution of MPT is the concept of the “efficient frontier.” This concept serves as the backbone of MPT’s approach to portfolio optimization, building upon the principles of correlation and volatility.
The Efficient Frontier is a graphical representation of optimal portfolios that offer the highest expected return for a defined level of risk. It is constructed using a set of theoretical portfolios that provide the maximum expected return for various levels of risk, based on the correlation and volatility of the included assets in different allocations.
On a graph of different portfolios, the Y-axis represents the expected return, and the X-axis represents risk, typically measured by standard deviation. The curve that connects the series of most optimal portfolios is known as the Efficient Frontier. Every point on this curve represents an optimized portfolio that has the maximum possible expected return for its level of risk.
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Importantly, portfolios that sit below the Efficient Frontier are considered sub-optimal, because they do not provide enough return for the level of risk they assume.
“The Efficient Frontier is an obvious target because it means that you own the most efficient investment combination, such that no other investment mix offers a higher return for the same amount of risk,” Moss says. “While the Efficient Frontier doesn’t ensure that you earn the maximum rate of return, it does help you maximize your risk-adjusted rate of return.”
Applying MPT to Your Portfolio
By understanding and applying the principles of MPT, investors can create a more resilient and potentially rewarding portfolio.
The starting point is the principle of diversification. It’s not enough to simply invest in different assets; proper diversification means choosing investments that are not highly correlated. This approach allows investors to potentially reduce their portfolio’s overall risk without necessarily sacrificing returns.
“By combining assets with varying risk and return characteristics that do not move in sync, portfolios can generate higher returns for lower volatility,” says Dan Tolomay, chief investment officer at Trust Company of the South. “In other words, the whole is greater than the sum of its parts.”
Correlation, or a lack of it, is paramount in this respect. While correlations between assets can fluctuate, some examples have held long-term trends. Consider the low correlation of bonds to stocks, or the negative correlation of commodities to bonds.
Another example is gold, which has historically exhibited a low correlation to both stocks and bonds, while possessing high volatility. By adding a small allocation of gold to a portfolio, an investor can potentially reduce overall volatility and drawdowns, without negatively impacting long-term returns.
“Diversifying within asset classes can also capture diversification benefits,” Tolomay says. “For stocks, consider international companies, multiple market caps, and styles such as growth versus value. While for bonds, geographic diversification is key, as is variation in credit quality and maturities.”
Finally, being able to visualize the Efficient Frontier can help investors select the optimal asset allocation in their portfolio to target a desired level of risk and return. For example, while a 60/40 portfolio of stocks and bonds may lie on the Efficient Frontier, meaning that it produces the highest expected return for the lowest risk, the returns still might not be enough for an investor’s objectives.
Therefore, an investor who understands MPT may consciously choose to apply leverage to a more efficient 60/40 portfolio, which historically has slightly exceeded the returns of a 100%-stock portfolio, but with lower volatility and thus greater efficiency. Hence, a higher risk-adjusted rate of return.
A real-life example is the WisdomTree U.S. Efficient Core Fund (ticker: NTSX), which provides exposure to a one-and-a-half times, or 1.5x, leveraged portfolio of 60% U.S. stocks and 40% U.S. Treasury bonds. If stock and Treasury correlations remain low, NTSX is expected to perform similar to a 100%-stock portfolio, but with lower risk, thanks to its application of MPT.
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Modern Portfolio Theory: What Is It? originally appeared on usnews.com
