Modern Portfolio Theory: An Introduction

Modern Portfolio Theory (MPT) is a financial concept that aims to help investors create a well-diversified portfolio that balances risk and return. It was first introduced by Harry Markowitz in 1952 and has since become a cornerstone of investment strategy. The theory suggests that by carefully selecting a combination of assets, investors can construct a portfolio that provides the highest potential return for any given level of risk.

The Basics of MPT

MPT is based on the idea that by combining different assets, an investor can reduce the overall risk of their portfolio. This is because different assets not only have different levels of risk and return, but also have different risk factors.  For example, interest rate changes will have different effects on long term debt, large US companies and industrial real estate.  Thus, by including a variety of assets, the portfolio is less likely to be impacted by a single market event.

The key to successful MPT is to understand the relationship between risk and return. The theory states that there is a positive relationship between risk and return, meaning that the higher the risk, the higher the potential return. This is why MPT suggests that investors should aim to diversify their portfolios, as this helps to reduce the overall risk of the portfolio while still allowing for the potential for high returns.

How to Implement MPT

Implementing MPT involves several steps:

1. Determine your investment goals and risk tolerance
2. Assess the risk and return of different assets
3. Create a diversified portfolio of assets that balances risk and return
4. Regularly review and adjust the portfolio as needed
   

When it comes to determining your investment goals and risk tolerance, it's important to consider both your short-term and long-term financial objectives. This will help you determine the level of risk you're comfortable with and the types of assets you should include in your portfolio.  You may have a different allocation in different parts of your portfolio.

Next, you'll need to assess the risk and return of different assets. This can be done by looking at historical performance data and projections for the future. You'll also want to consider factors such as volatility, liquidity, and correlation, as these can all impact the risk and return of an asset.

Once you have a clear understanding of the risk and return of different assets, you can start creating your diversified portfolio. This may involve including a mix of stocks, bonds, and other investment vehicles, as well as allocating your assets in a way that balances risk and return.

It's important to regularly review and adjust your portfolio as needed. This can involve monitoring market conditions and adjusting your asset allocation to ensure that your portfolio remains well-diversified and aligned with your investment goals.

The Benefits of MPT

There are several key benefits to using MPT:

1. Diversification: By including a mix of assets in your portfolio, you can reduce the overall risk of your investments.
2. Potential for higher returns: By understanding the relationship between risk and return, you can make informed decisions about which assets to include in your portfolio, potentially increasing your potential for high returns.
3. Better risk management: By regularly reviewing and adjusting your portfolio, you can better manage the risk of your investments and ensure that your portfolio remains well-diversified.
4. Improved investment decision-making: MPT provides a framework for making informed investment decisions, helping you to make decisions that are aligned with your investment goals and risk tolerance.

Modern Portfolio Theory is a powerful tool for investors looking to create a well-diversified portfolio that balances risk and return. By following the steps outlined above and regularly reviewing and adjusting your portfolio, you can potentially increase your potential for high returns while reducing the overall risk of your investments.

Click here to schedule a free, no obligation financial review or click here to if you have a question for our team of CFP Professionals, Linus Whitlock CFP® and Logan Whitlock CFP®.