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Modern Portfolio Theory

Modern Portfolio Theory is a calculated and disciplined approach to investing in a portfolio of assets.  It is an approach that looks at expected returns, risk (standard deviation and variance), correlations and other statistical measures of asset classes.  In 1990, Harry Markowitz was awarded the Nobel Prize in economics for this pioneering work.  Here are some of the basic tenets of Modern Portfolio Theory:

 

  • Investors are risk averse.  The only acceptable risk is that which is adequately compensated by potential portfolio returns.

 

  • Markets are efficient.  It is virtually impossible to anticipate the future direction of the markets as a whole or of any individual security.   Therefore, timing the purchase or sale of investments in the attempt to “outperform the market” is highly unlikely to increase long-term investment returns; they also can significantly increase portfolio operating costs.  It is unlikely that any portfolio will succeed in consistently “outperforming the market”.  

 

  • The design of the portfolio as a whole is more important than the selection of any particular security within the portfolio.  The appropriate allocation of capital among asset classes (stocks, bonds, cash, etc.) will have far more influence on long-term portfolio results than the selection of individual securities.

 

  • For a given level of risk, an optimal combination of asset classes will maximize returns. Diversification helps reduce investment volatility.  The proportional mix of asset classes determines the long-term risk and return characteristics of the portfolio as a whole (diversification does not guarantee against market losses.  It is a method used to help manage risk).


  • Portfolio risk can be decreased by increasing diversification of the portfolio and by lowering the correlation of market behavior among the asset classes selected.  Correlation is the statistical term for the extent to which two asset classes move in tandem or opposition to one another.


  • Equities offer the potential for higher long-term investment returns than cash or fixed income investments.  Equities are also more volatile in their performance.  Investors seeking higher rates of return must increase the proportion of equities in their portfolio, while at the same time accepting greater variation of results (including declines in value).