Modern portfolio theory (MPT) is built on asset allocation, diversification, and portfolio rebalancing without letting human emotion interfere.
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It’s hard to argue that the first half of 2021 wasn’t good for major stock indexes.
The S&P 500 Index (SPX) rose 14.4% for the first six months of 2021, while the Nasdaq Composite (COMP:GIDS) and the Dow Jones Industrial Average ($DJI) each gained more than 12%.
But if history offers any guidance, the market won’t continue going up without taking some type of break. Or running into turbulence in the form of volatility. As tempting as it is to have all your financial eggs in one basket when things are going well, managing risk—even when those ticker symbol lights continue to blink green—can be an essential consideration for long-term investors.
An optimal investment portfolio has assets with a chance to perform well regardless of market direction and suits your risk tolerance and investment target time frame. One way to possibly achieve this is through using techniques prescribed by modern portfolio theory, or MPT, that aim to acknowledge returns for any given risk.
“The idea is to smooth out your financial journey and to insulate your portfolio from extremes,” said Viraj Desai, senior manager, portfolio construction at TD Ameritrade.
Although incorporating MPT can’t promise such results, it’s something long-term investors might find useful along the way.
The term MPT was first penned in 1952 by economist and Nobel Prize laureate Harry Markowitz, who used mathematics to support his theory that investors can potentially minimize risk and maximize returns by holding a combination of asset classes that aren’t correlated to each other.
MPT is a basic yet fundamental investing model that embraces diversification while sticking to a measured regime of the classic buy low/sell high through ongoing rebalancing. If an investor can stick to this type of discipline, it’s sometimes less painful to ride out the downmarkets by staying diversified and not making rash moves to buy or sell when the market is going up or pulling back significantly.
MPT cannot—and does not claim to—eliminate “systematic” risk, or what happens when the entire market takes a tumble. But it can sometimes soften the blow. With MPT, the idea is to spread the risk among assets that don’t typically behave in the same way. It can be distilled down to these three components:
MPT is aimed at helping dodge what’s called “undiversifiable” risk, or what happens when all your investments are in one asset class and that asset class stumbles. Think about the Great Recession of 2007-09: If all your money was tied up in stocks, you likely lost a chunk of change.
Those who held some U.S. Treasuries during that period, however, perhaps saw their portfolio take less of a hit with these low-credit-risk assets held to provide balance. Other scenarios could include holding domestic and international stocks, Treasuries, and credit instruments. Or even commodities.
“This idea is important because it helps us manage our behavior when it comes to our portfolios. You want to avoid loss aversion, or behaving in a rash manner,” Desai explained. You don’t want fear to be the motivator to sell everything or to buy it all back. A thoughtful, balanced approach is considered a more optimal way to make financial decisions.
“Using techniques prescribed by MPT aim to help investors be more risk averse and less loss averse, if the risk tolerance you have aligns with your portfolio construction,” Desai commented.
Using MPT techniques 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 and 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.
But if you’re in your 60s, when time has snuck up on you, those who subscribe to MPT believe that it’s best to protect your wealth by taking a more conservative approach without swaying too far from your goals.
“MPT is about managing risk in up and down markets throughout your financial journey,” Desai said. “Ideally that’s not about just leaning into the markets, it’s about smoothing out potential risks to your accumulated wealth.”
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