Investing has the potential for extreme volatility and losses. However, modern portfolio theory (“MPT”) provides a framework for constructing portfolios that maximize returns for a given level of risk.
Let’s explore the strategies behind what’s known as “risk-adjusted investing” based on MPT.
MPT: background
Modern portfolio theory was developed and introduced by Harry Markowitz in his 1952 essay “Portfolio Selection” and his 1959 book “Portfolio Selection: Efficient Diversification of Investments.”
Markowitz was awarded the Nobel Prize in Economics in 1990 (along with Merton Miller and William F. Sharpe) for this contribution over 30 years later. His foundational theories introduced mathematical optimization techniques to investment practices.
MPT is an investment framework based on the idea that investors can construct portfolios to optimize expected returns for a given level of risk.
Key principles of MPT
The fundamentals of MPT are:
Diversification: Investors can reduce portfolio risk by holding assets that have low correlations, i.e., the prices do not tend to move up and down together. This allows for the same expected return with lower risk.
Efficient frontier: The efficient frontier is a critical concept in MPT. It refers to the set of optimal portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given expected return. The efficient frontier helps visualize the trade-off between portfolio risk and return to identify mathematically optimal asset allocations based on an investor’s goals and risk tolerance.
Asset class risk/return: MPT uses statistical analysis to determine the expected risk/return profiles of asset classes like stocks, bonds, and real estate to generate optimal allocations.
Target asset mix: MPT aims to determine an ideal long-term asset allocation across classes like equities, fixed income, and cash based on an investor’s risk tolerance and goals
Rebalancing: Rebalancing refers to periodically adjusting a portfolio that deviates from its target asset allocation to the original desired allocation. The main goals of rebalancing are to control risk, enhance returns, and maintain the intended asset mix over time.
Rebalancing is important in MPT because it helps maintain the desired asset allocation optimized for a particular risk-return profile.
Input Assumptions: Input assumptions refer to the estimates and forecasts used for variables like asset class returns, volatility, and correlations. Input assumptions include:
- Expected Returns – Forecasts for the future returns of each asset class (stocks, bonds, etc.) over a particular time horizon, typically long-term.
- Volatility – The standard deviation or price variability for each asset class. It is used to quantify investment risk.
- Correlations – The statistical relationships between asset class returns. Low correlations increase diversification.
- Time Horizon – The intended investment timeframe, as return assumptions may differ for short vs. long horizons.
- Market Period – Input data may be based on long-term historical averages or a more recent, shorter market period.
- Risk Tolerance – Return expectations are adjusted based on an investor’s ability and willingness to bear risk.
- Other Constraints – Factors like tax considerations, liquidity needs, and legal and regulatory limits.
- Sensitivity Analysis – Testing how the optimal asset allocation changes when input assumptions are varied.
MPT is highly dependent on the accuracy of the inputs used. Small changes in expected returns can impact the output significantly.
Criticisms of MPT
Critics of MPT believe its underlying assumptions are flawed; it ignores behavioral biases; it focuses only on quantifiable risk; it provides only a single optimal portfolio for each level of risk and its reliance on historical data, which makes it impossible to estimate risks for newer assets with limited data accurately.
Why you should care
Here are some potential consequences of not having a portfolio based on modern portfolio theory (MPT):
- Sub-optimal asset allocation. MPT helps determine the optimal asset allocation that maximizes expected return for a given level of risk. Without considering MPT, your asset allocation may not be optimized.
- Failure to properly diversify. MPT emphasizes the importance of diversification in reducing portfolio risk. Without adhering to MPT, you may have a concentrated portfolio lacking proper diversification.
- Lower risk-adjusted returns. MPT aims to construct a portfolio that maximizes returns for a given level of risk. Without MPT, your portfolio is unlikely to offer the highest possible return per unit of risk.
- Increased exposure to unsystematic risk. MPT aims to minimize unsystematic risk through diversification. Without diversification, your portfolio has higher exposure to risks specific to individual assets.
- No consideration of correlations. MPT accounts for how assets move in relation to each other. Ignoring correlations means you could end up concentrating in assets that move together, further compromising diversification and increasing risk.
- Sub-optimal weighting. MPT helps determine the optimal weight for each asset in a portfolio. Without considering MPT, investments may be improperly weighted.
The main consequence of not having a portfolio based on MPT is that your portfolio is unlikely to be optimized for risk-adjusted returns. You may take on unnecessary risks for the level of returns generated.
The role of a financial advisor
A financial advisor plays a vital role in applying MPT to recommend an optimized portfolio:
Gathering Inputs: The advisor works with clients to understand their risk tolerance, goals, time horizon, and other constraints to determine appropriate input assumptions.
Asset Allocation: The advisor uses MPT modeling and analysis to determine an appropriate asset allocation across equities, fixed income, and cash.
Investments: The advisor selects appropriate investment products like mutual funds or ETFs for each asset class in the recommended allocation.
Implementation: The advisor implements the portfolio recommendation and handles tasks like account opening, fund purchases, and transfers.
Rebalancing: The advisor periodically monitors and rebalances the portfolio to target allocations.
Risk management: The advisor helps manage risks by reallocating if the client’s tolerance for risk or need to take risk changes.
Ongoing Service: The advisor provides continuing portfolio reviews, guidance, and discipline to stick to the strategy long-term.
At Allied Integrated Wealth, we are familiar with the principles of MPT and implement the principles underlying it when recommending portfolios to our clients.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.