Building an investment portfolio can be one of the biggest challenges in managing your money. You want your portfolio to grow, but you also want to protect your hard-earned nest egg. After all, your financial future depends on it. Should you aim for maximum growth or prioritize safe and stable investments? Every investor faces these questions.
In the 1950s, Nobel Prize winning economist Henry Markowitz1 developed Modern Portfolio Theory (MPT), which revolutionized the way people think about investing. The main idea of MPT is that by combining different types of investments into a portfolio, you can balance risk and reward to help achieve your financial goals.
While MPT is complicated, learning the basics can help you feel more confident and make smarter investment decisions.
What Is Modern Portfolio Theory?
The main purpose of modern portfolio theory is to help investors build portfolios that hopefully achieve the highest possible return at every given level of risk. Conversely, using MPT can help minimize risk at any desired level of return. You can use either risk or return as your starting point.
There are two key concepts that underpin MPT.
Diversification: Spreading your money across different assets reduces the probability that one bad investment can tank your whole portfolio. The goal is to choose assets that won’t all move in the same direction at the same time.
Efficient Frontier: This is a set of so-called “optimal” portfolios that offer the highest return for a certain level of risk or the lowest risk for a specific return.
MPT can help you find the sweet spot between risk and return by using some data and a few calculations to help you build a portfolio that’s consistent with your financial goals and appetite for risk.
How to Use Modern Portfolio Theory to Inform Your Investing
Whether you’re building a portfolio yourself or working with a financial advisor, there are a few steps you can take to put MPT to work for you.
Step 1: Identify your financial goals and risk tolerance
Before you get to the point of making any calculations, there are two things about which you need to be very clear.
Your investment goals: Are you investing for retirement, a downpayment on a house, or a child’s education? Your goals determine the investment time horizon and target return.
Your risk tolerance: A number of factors play into how much risk a person should be willing to assume. It depends on age/investment time horizon, income, and financial stability, among other things. Another key determinant is personality, as tolerance for risk varies widely among individuals.
Once you’ve taken this step, you’ve laid the foundation for selecting the right mix of investments.
Step 2: Understand and measure risk
Risk is an essential component of MPT and is measured by standard deviation. Standard deviation measures the spread of asset prices around their average price and illustrates market volatility.2 The higher the standard deviation, the riskier the asset.
For example, a relatively less risky investment like a government bond might have a low standard deviation because returns are steady, while a high-growth tech stock is likely to have a high standard deviation because performance can swing wildly from year to year.
When you’re ready to start using MPT, you can find the standard deviations for mutual funds, ETFs, and stocks on most financial platforms.
Step 3: Calculate expected return
There are several different ways to calculate or identify the expected return.
The capital asset pricing model (CAPM) is used to predict an investment’s expected return based on its risk relative to the market (beta) and the market’s overall expected return.
You can also use estimated expected returns based on your own or others’ expectations. Analysts often publish their estimates, which are based on multiple factors they track closely.
This calculation will be specific to the asset or asset class you’re considering, so it can be used to theorize what each investment might contribute to your portfolio.
Step 4 Find the correlation between assets
This is where the diversification magic really happens. As you might recall, diversification works to reduce asset specific risk (also known as unsystematic risk). Some assets go up when other assets go down, and this minimizes overall risk.
The relationship between assets is measured by their correlation, which ranges from -1 to 1.
A correlation of 1 means that two assets move in the same direction in lockstep. A zero correlation means that their movements are unrelated, while a correlation of -1 means they move in opposite directions and have a negative correlation.
Modern Portfolio Theory suggests you want to combine assets that have low or negative correlations. For example, stocks and bonds have a low correlation and their performance is likely to be offsetting.
A little research will yield some general rules you can follow. For example, a commodities fund would likely see its value rise during periods of inflation when commodities prices rise. A fund overweighted in consumer cyclicals, which are very sensitive to inflation, would see its value likely fall in an inflationary environment.
If you want to take a more quantitative approach, platforms like Yahoo Finance and Morningstar often provide correlation analysis tools.
Step 5: Build your portfolio
Based on the data regarding risk, expected return and correlation, it’s time to build a portfolio.
Asset Allocation: This is the first step in building a portfolio. Decide what percentage of funds you want to allocate to different asset classes. Many factors beyond the quantitative go into the asset allocation decision. For example, age, time horizon, risk tolerance, and personal financial goals, as well as the need for diversification, all play a role in the decision.
Calculate Portfolio Risk: Calculate the overall portfolio’s standard deviation considering the risk (standard deviation) of each investment and the correlations between them.
Plot the efficient frontier: Many investment platforms can generate this graph for you. It gives a visual depiction of the best portfolios at different risk levels. However, every investor may not have access to such capabilities.
Remember, the efficient frontier illustrates the “best” portfolio for different levels of risk. Consequently, it requires input data. Asset classes and allocations are the building blocks of the efficient frontier. It’s necessary to calculate risk (standard deviation) to understand how the asset allocation behaves. The efficient frontier uses this data to determine the risk/return tradeoff. Without calculating risk, you can’t know where the portfolio stands relative to the efficient frontier.
At this point, you’re probably feeling as though you should lie down with a cool cloth on your forehead. Why in heaven’s name would anyone do this?
The good news is that you don’t have to do any calculations to apply MPT, because tools exist online. For example, there are online portfolio analyzers from Morningstar and Portfoliovisualizer. Major robo-advisors automatically apply MPT-based strategies. All these platforms can make it easy to experiment with different asset combinations and find a mix that is consistent with your goals.
No Calculations Necessary
Whether you work with an advisor or take advantage of some of the tools we’ve discussed, simply understanding MPT can help you make smarter decisions when you’re trying to balance risk and return in your portfolio.
Diversification: This is one of the most important principles in investing. Even if you’ve never heard of MPT, you’ve heard of diversification. But if you have a basic understanding of MPT, you can better understand how diversification works, and you can strive to reduce the overall risk in your portfolio and seek to achieve more stable returns over time. When you’ve spread your risk across many different assets, you’ve reduced the risk that one disastrous investment can have an oversized impact on your overall portfolio return.
Risk-Return Tradeoff: If you understand MPT and know that the efficient frontier exists, you will know that for the level of risk you’re willing to undertake, there is a portfolio that should give you the highest possible return for that level of risk. Alternatively, if you have a target return in mind, you can seek to achieve it with the lowest possible risk. Keeping that framework in mind can inform your decisions when you work with an advisor or use tools available through various investment platforms.
Reduce emotional decision-making: Emotion is the kiss of death for investors, especially during downturns. When prices drop, some investors might panic and sell. When markets surge, they clamor to jump on the bandwagon, buying at the top of the market. When you’ve built a portfolio based on MPT, you can have confidence that you’re positioned for stability in the spectrum of market conditions, helping you avoid rash moves.
The Takeaway
Modern portfolio theory is the foundation for your entire portfolio. Whether you’re looking at the fixed income allocation or your most aggressive equity allocation, the efficient frontier still applies. No matter the level of risk, there is a portfolio designed to seek the highest level of return for that level of risk.
MPT helps you focus on consistent, reliable performance rather than speculative bets. While diversification might mean missing out on the full impact of a blockbuster, it can also mean missing out on a catastrophic loss. Over the long term, this approach is intended to lead to stronger, more stable growth.
While the theory encourages caution, it doesn’t limit the potential to grow wealth. Instead, it gives you a framework to take reasoned, calculated risks based on your goals and comfort with risk. Whether you’re a conservative or aggressive investor, MPT-based strategies can adapt to meet your needs.
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