Modern Portfolio Theory and the Value of Diversification

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What are your financial goals, and how can you achieve them?

These are the two fundamental questions of any portfolio strategy. While answering the first question may be fairly straightforward, the second, as we all know, is quite a bit more challenging.

In this post, I seek to help you answer that question by first, shedding light on the essential investing theories and second, by showing how they apply in practice. The great thing is that the theories work across the board, no matter the size of your account. The same essential principles that we used when I worked at the Stanford Management Company – which manages Stanford University’s $18.7 billion endowment – also apply to an individual investor’s portfolio.

So just what is the practical starting point of any investing strategy?

Portfolio diversification – which is best explained through the concepts of Modern Portfolio Theory. This theory, developed by Nobel Economist Harry Markowitz in 1952, represents one of the greatest developments in our understanding of risk in this century. While a great deal of mathematical modeling and imperfect assumptions underlie the theory, I will present in this blog post the key concepts to provide you with a basic framework to understand how this theory helps you achieve your own financial goals.

Risk, Return, and the Efficient Frontier

One of the core concepts of modern portfolio theory is that a tradeoff exists between risk and return. The idea here is that the more risk you are willing to take, the greater the return you can achieve. Different types of investments have exhibited similar levels of risk and return – each of these broad groups are considered to be asset classes. Examples of asset classes include equities, fixed income, and “real assets” (i.e. physical assets like real estate and commodities). Certain asset classes are inherently riskier than others, and therefore have a higher expected return associated with them.

Furthermore, asset class returns are not perfectly correlated. Simply put, different market conditions are more or less favorable for different investments. When fixed income investments are performing well, equities may be performing poorly. With the knowledge of expected return and risk for each asset class as well as their correlations to each other, you could, in theory, determine the combinations of investments that would result in the highest level of return for any given level of risk. The set of portfolios that generates the optimal returns for each level of risk is what we call the “efficient frontier.”

The Link to Diversification

The problem that you face as an individual investor is that you do not have the time or most likely the resources to determine exactly what that efficient frontier looks like. You would probably be discouraged to hear that not only would it be hard to determine the composition of these “optimal portfolios” on your own, but it is subject to a number of constraints and imperfect assumptions.

But don’t stop reading here!

The concept of an efficient frontier reveals a very simple but key investment insight. Understanding that the efficient frontier represents the set of investment portfolios that provide the greatest return for the risk you take – in other words, the most bang for your buck – we can infer that investing across multiple asset classes allows for a better return for a given level of risk than could be achieved with one asset class alone.
This insight brings us to the most important practical concept for managing your investments: diversification.

Diversification has been called the only free lunch investing, because relative to holding a single investment, diversifying across asset classes allows you to maintain the same level of return you had before, at a lower level of risk.

Applying Modern Portfolio Theory to your Investments

Modern Portfolio Theory is subject to a number of limitations and imperfect assumptions. It should serve as a guide, not a black box. At Personal Capital, our portfolio management team uses the theory as a basis for investment strategies, but incorporates some adjustments for real life circumstances.  With the new Personal Capital Investment Checkup tool, you can see how well your portfolio uses risk and how it compares to a personalized, recommended asset allocation.

Returns are volatile in the short run over market cycles, but if you are investing with an eye towards retirement or long term investment goals, your best bet is to diversify across asset classes.

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Susan Pohlmeyer, CFA

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Disclaimer. This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.