A Simple Theory To Maximize Investments
Modern Portfolio Theory, or MPT, is about maximizing the return investors could get in their investment portfolio considering the risk involved in the investments.
If you are interested in getting the maximum returns (after all isn't that why you invest?) for your investment dollars over the long-term you will want to understand and apply Modern Portfolio Theory, or MPT.
This is is an investment approach developed by an American economist, Harry Markowitz. Markowitz was awarded the Nobel Memorial Prize in Economic Sciences in 1990 for his work developing this theory. It is also the foundational approach of many portfolio managers who often charge clients annual fees of 1 or 2 percent annually to rebalance client portfolios following this approach.
But you don’t have to pay annual fees as those fees actually reduce you fees returns over time. You can either follow this approach yourself or invest with a robo-advisors like Betterment, Wealthfront, AxosInvest or even Acorns. Each of these will create a broadly diversified portfolio for you following the ideas of MPT. With Acorns the minimum to start is only $5 a month. With the others plan on investing at least $50 a month.
What Is Modern Portfolio Theory?
With Modern Portfolio Theory you take a look at investing as way to get the maximum returns with the least acceptable risk for whatever investment dollars you have.
Markowitz, first published his theory in a 1952 paper published by The Journal of Finance, as a way to create a portfolio of assets to maximize returns within a given level of risk, and/or to devise a portfolio with a desired, specified and expected level of return with the least amount of risk. You just have to realize that every investment has some risk. With MPT you have a least defined the level of risk you are willing to take.
One thing that Markowitz wanted do was to eliminate the risk with each investment because of the investment's unique characteristics. He developed the idea that investors can design a portfolio to maximize returns by accepting a quantifiable amount of risk that fits their comfort level.
As an investor one thing you decide is what sort of risk taker you are, from very conservative to aggressive. You can then select investments more in line with your desire to avoid or take risks.
In other words, investors could reduce risk by diversifying their assets and asset allocation of their investments using a quantitative method.
With a balanced portfolio, when some assets fall due to market conditions, others should rise near equal amounts in compensation, according to the theory.
Markowitz suggests that by looking at a portfolio as its whole, it was less volatile than the total sum of its parts. This is similar to the idea of building a core investment portfolio before branching out to other (perhaps more risky investments).
When you decide to have a "diversified portfolio," your task is to divide your assets by percentages in different investments, for example -- 60% stocks (40% large-cap, 20% small-cap), 20% fixed income (think bonds) and 20% commodities. Guess what? you have applied Modern Portfolio Theory to your allocation of assets. If (or when) your stocks outperform bonds, the theory requires you to bring the allocations back into balance by buying more bonds, or perhaps selling some of the stocks. Seems challenging but the idea is you are reducing your risks and maintaining a level of return that is aligned with you desire to maintain a certain level of risk. A perfect way to simply maintain your investments without taking on risks that you are not comfortable with.