No man is an island, and according to modern portfolio theory (MPT) — no investment is either. The theory provides a foundation for building a portfolio of multiple investments to address the dual goals of minimizing risk and optimizing portfolio returns.
Here’s a closer look at modern portfolio theory and how it could help with building a portfolio that’s in line with an investor’s goals.
Image Credit: utah778 / iStock.
Modern portfolio theory: the basics
In 1952, Harry Markowitz published an article in The Journal of Finance that first proposed modern portfolio theory. According to his theory, investors are risk-averse.
They don’t like volatility, and they get increasingly nervous as risk rises. But this puts investors in a bit of a bind. The whole goal of investing is to get some kind of return, and high returns are associated with higher risk.
So what’s an investor to do? Find a way to strike a balance between taking on enough risk to meet return goals and not so much that they can’t stomach it.
Enter MPT, an investment model that could potentially help investors maximize their expected return based on a given level of market risk.
In short, investors could decide how risky they want their portfolio to be and calculate the mix of assets that would give them the highest return at that level. Markowitz won a Nobel Prize for his work on MPT in 1990.
The theory also seeks to eliminate idiosyncratic risk, the risk inherent to individual investments. For example, imagine you own stock in one pharmaceutical company and a firm-wide scandal sends the stock price plummeting, an issue that has little to do with the overall market.
According to MPT, investors should be able to reduce both types of risk through asset allocation and by diversifying the types of investments they hold. When some investments lose value due to market conditions, others will make up for it by gaining in value.
In this way, the portfolio as a whole may be less volatile — and therefore less risky — than the individual pieces that make it up.
For example, stocks are generally considered to be more volatile and subject to more market risk than bonds. Though stocks typically offer a relatively high return, the risk associated with that return may be too much for many investors to stomach.
However, a portfolio that consists of a mix of stocks and bonds may offer relatively high returns with a more acceptable level of risk.
Image Credit: utah778 / iStock.
Why is modern portfolio theory important?
Many financial advisors use MPT to help build their clients’ portfolios, and the same tenets of asset allocation and diversification could be used if an investor wants to build a portfolio on their own.
When building a portfolio, investors will generally consider how much risk they are willing to take on, also known as your risk tolerance.
In general, younger investors could take on more risk because they have more time to ride out the market’s ups and downs.
Older investors who may need to draw on their investments sooner may have lower risk tolerance, since they lack the time to recover from a market downturn.
Once an investor establishes their risk tolerance, they might allocate their portfolio among assets that have different risk and return characteristics, such as stocks, bonds and cash equivalents.
For example, a portfolio might hold 60% stocks, 35% bonds and 5% cash equivalents, such as certificates of deposit. Within each asset class, they’ll likely further diversify by including different types of instruments and sectors.
A stock portfolio might hold 50% large-cap equities, 30% small-cap equities and 20% foreign equities.
A financial advisor could help an investor make these decisions, or an investor can research investments and allocation on their own. Rather than individual stocks, an investor might consider using mutual funds or exchange-traded funds, which already hold a basket of different types of assets, to diversify.
Image Credit: Chainarong Prasertthai / iStock.
Calculating expected return and calculated risk
Whether an investor is building their own portfolio or leaving it to the professionals, it’s useful to know how to calculate risk and return according to MPT.
Let’s start with return. To calculate a portfolio’s expected return, consider the weighted average of each asset’s expected return. Say an investor has a portfolio worth $100,000. For simplicity’s sake, let’s say that money is divided between two assets. They have $60,000 invested in asset A, and they want a 10% return. They have $40,000 invested in asset B and want a 5% return.
To figure out the expected returns for the portfolio, divide the value of each asset by the total value of the portfolio. Then multiply by the expected return. For asset A the calculation would look like:
(($60,000/$100,000) X 10%) = a 6% return.
Repeat this calculation for asset B:
(($40,000/$100,000) X 5%) = a 2% return.
To finish up the calculation for total portfolio expected return, add the returns of the individual assets together. In this case 2% plus 6% equals 8%. To change the total expected returns, investors can shift money from one asset to the other.
Similarly, investors could also use MPT to quantify risk in the portfolio. MPT gives us a risk-measuring statistic known as “beta.”
Beta is a measure of volatility of an asset in comparison to the market as a whole. A beta of one means that the systematic risk of a portfolio is the same as the overall market. A beta higher than one is more risky, and a beta less than one is less risky.
To calculate the overall risk of a portfolio, let’s now imagine that an investor has $50,000 invested in both assets A and B. Asset A has a beta of one and asset B has a beta of 1.4. You can calculate the beta for each asset by multiplying its weighting—in this case 50%—by its beta. Here, the total beta for the portfolio is:
(50% X 1) + (50% X 1.4) = 1.2
By adjusting the weighting of each asset, the investor can shift the portfolio’s risk up and down. They could also add another asset that is more or less risky to help bring the portfolio into the desired balance.
Image Credit: DepositPhotos.com.
What is the “efficient frontier?”
There is more than one way to construct a portfolio that will meet an investor’s risk and return goals.
The efficient frontier is a tool invented by Markowitz to help investors identify the portfolios that offer the best returns for a given amount of risk. Here’s how it works:
Every combination of assets is plotted on a graph where the x-axis represents portfolio risk and the y-axis represents return. The efficient frontier is the line curve that represents the maximum amount of return for any given amount of risk.
The portfolios that fall on the curve represent the greatest potential return, while portfolios below the curve offer a less-than-ideal rate of return, since investors should be able to get a higher return for the same risk by choosing a portfolio closer to the curve.
Image Credit: Pinkypills / iStock.
Criticisms of modern portfolio theory
Some critics suggest that there are a few pitfalls when it comes to MPT. The theory doesn’t build in the cost of taxes or transaction fees, for example. It also relies heavily on historical precedent.
While the stocks and bonds have historically moved in different ways — in other words they are uncorrelated — there is no rule that says this pattern will hold forever. What’s more, the theory suggests that volatility is predictable and that investors make rational decisions, neither of which is necessarily true.
The bottom line is, while MPT may have some flaws, it can still be a powerful tool to help an investor build a portfolio that manages risk while maximizing return.
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA/SIPC. The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
Image Credit: GaudiLab // iStock.AlertMe