Modern portfolio theory (MPT) is built on asset allocation, diversification, and rebalancing your portfolio without letting human emotion interfere.
An optimal investment portfolio contains assets intended to show well in the light and in the dark. That means it’s built to suit—for your risk tolerance and target time frame, for moments of market clarity and uncertainty.
We’re talking about modern portfolio theory (MPT), which aims to optimize potential returns for nearly any given risk. Modern portfolio theory has a fresh-sounding resonance, but it’s a 63-year-old investing model structured on three elements: asset allocation, diversification, and periodic rebalancing. At its roots, MPT is a basic investing model—and by now a fundamental one—that embraces diversification and equilibrium while sticking to a measured regime of the classic buy low/sell high.
“The idea is that by sticking to that kind of discipline, you can ride out the down markets by staying diversified, and not making rash moves when the market is going up significantly or pulling back,” says John Bell, director of guidance platforms and tools at TD Ameritrade.
For example, asset classes whose prices go sharply higher tend to become overweighted and could warp the balance.
“If you’re consistently rebalancing back to a target, in general you will be selling the assets that are most highly valued and overpriced, and buying those things that are undervalued and underpriced,” Bell adds.
“Buy low/sell high is what rebalancing allows you to do without attempting to introduce biases into your analysis. The beauty of calendar-based rebalancing is there’s nothing more magical about it other than enforcing some discipline,” he says.
Modern portfolio theory was first penned in 1952 by economist and Nobel Prize laureate Harry Markowitz, who used mathematics to support his theory that you can minimize risk and maximize returns by holding a combination of asset classes that aren’t correlated to each other and that align with your personal appetite for risk as well as your age.
In other words, with MPT, you spread the risk among assets that don’t typically behave in the same way. It all boils down to these three components:
Why such lasting power for MPT? Because self-control practiced through rebalancing manages two emotions that typically prompt investors to make bad decisions: greed and fear.
“Human behavior sometimes trumps logic and sound thinking,” Bell says. “People tend to buy at the absolute worst time and sell at the absolute worst time. Discipline takes the human emotion part out.”
But MPT is not bullet-proof. It’s aimed at helping you dodge what’s called “undiversifiable” risk, or what happens when you have all your investment eggs in one asset-class basket and that class stumbles. If all your money was tied up in stocks in 2008, you likely lost a big chunk of change.
MPT also follows a basic school of thought about accumulating and keeping wealth. In your 20s, when you have decades of investing before you, conventional wisdom urges taking more risks, perhaps investing more heavily in equities than fixed income in your portfolio weightings. The assumption is that you have time to recover from a harrowing market event that could wipe out 50% of your portfolio. Remember 2008?
But if you’re in your 60s, when time has snuck up on you, MPT says it’s best to protect your wealth by taking a more conservative approach without swaying too far from your goals. Those who ran for the hills and converted equities to cash in 2008 probably missed the bull market that followed.
MPT cannot—and does not claim to—eliminate “systematic” risk, or what happens when the entire market takes a tumble. But it can soften the blow. Rather than suffering a 50% loss along with the stock-market crash of 2008, a well-balanced portfolio may have set you back only 25% or sometimes less.
“You'll very rarely ever be at the top or the bottom of a broad group of asset classes, but most likely in the middle. That makes sense, because you have a mix of all the asset classes,” Bell says.
Carefully consider the investment objectives, risks, charges and expenses before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2020 TD Ameritrade.