With the recent market volatility and economic meltdown it’s become increasingly rare to find investors (or their financial advisors) who can succinctly answer the question “what’s my (your) investment plan?” That fundamental question undeniably exposes gaping holes in the average investors long term plan for financial security.
Without a blueprint – you can’t build a house! Without a focal investment strategy most investors (and their financial advisors) make emotional, illogical, and often irrational investment decisions to their own financial detriment.
In 1990 Harry M. Markowitz, then a professor at Baruch College of the City University of New York, won a Nobel Prize in Economic Sciences. His lifelong studies in the fields of investment risk, investment return, security correlation and portfolio diversification are the basis of what we know today as “Modern Portfolio Theory”, or “MPT”.
Modern Portfolio Theory is well-known in the investment community as a rational basis for sound portfolio management principles. Modern Portfolio Theory should serve as a foundation for your investment planning “blueprint” as well.
The crux of Modern Portfolio Theory (MPT) is the relationship between investment risk, return, and correlation. Those factors are charted on what’s called the “efficient frontier” graph. The efficient frontier graph illustrates a securities expected return and the risk associated with achieving that expected investment return.
On the left of the efficient frontier graph (the Y axis) is the expected investment return plotted vertically. The horizontal footing (the X axis) is a measurement of a security’s expected risk (as illustrated by it’s standard deviation).
The efficient frontier is a gently sloping arch stretching upwards, starting in the lower left corner and fading into the upper right corner. That gently sloping line represents portfolio possibilities providing the maximum long term expectation of portfolio return, with the least risk (volatility or standard deviation) possible.
A portfolio on the efficient frontier line is said to be “efficient” or “optimized” to garner the maximum financial benefit for each unit of risk exposure.
On the same chart as the efficient frontier you could have multiple asset classes plotted in a seemingly random fashion. United States treasuries would be plotted with little return and little risk in the lower left corner of the X & Y axis. Asset classes such as emerging market equities (stocks) would be plotted in the far upper right corner of the graph representing a high level of risk with a high potential investment return. United States equities would fall somewhere in between them representing moderate risk and moderate investment return (when compared to treasuries and emerging market equities).
Each asset class has a historical “correlation” to another asset class, meaning some investment securities perform differently at different periods in our economic cycle. For example, in 2008 commodities like gold and oil fluctuated wildly both up and down in value while United States equity holdings floundered through the third quarter, then sank dramatically in the fourth quarter as commodities stabilized. Treasury bond prices tended to trend upwards as interest rates came down.
These are excellent examples of “non-correlation”. Asset class investments performed good or bad relative to each other, and although most asset classes ended up lower in value, there were varying degrees of investment loss.
The efficient frontier is comprised of portfolio solutions which statistically balance asset class correlations with their expected investment return and risk. These portfolio solutions are fully diversified and contain no securities or investment holdings with specific risk exposure.
It is not possible to have a portfolio plotted ABOVE the efficient frontier, as it would have corresponding higher expected return and lower expected risk than what is possible given the available information. It is however possible to have a portfolio plotted BELOW the efficient frontier line – or what we call an “inefficient portfolio”.
The majority of investors have “inefficient” portfolios, meaning they’re taking on more investment risk than their expected investment return would require based on available information and expectations for the future. Modern Portfolio Theory states how rational investors use diversification to optimize their investment portfolio. MPT should in theory provide an investor with the greatest possible investment return for any given level of investment risk.
Are you invested like a pro? Or an average Joe? If your investment plan is fully diversified (no specific risk exposure) using several asset class investments such as:
- US Large Companies
- US Small Companies
- International Companies
- Emerging Markets Companies
- Real Estate Investments
- Fixed Income Investments
and the percentage allocation to those asset classes is weighted appropriately (which is based on correlation and typically determined by software programs available through many online investment custodians), chances are you’re invested more like the pros, than like the average Joe’s!
The average Joe investor throws bits and pieces of different mutual funds, stocks, exchange traded funds, bonds, etc. into a portfolio and calls it “diversified”. Chances are good, however, they’re actually not thoroughly diversified and haven’t eliminated all of the specific risk in their portfolio. In addition, they may or may not have added enough non-correlative asset classes to their investment strategy to effectively reduce the systematic risk to the greatest extent possible.
Modern Portfolio Theory has it’s faults however. The correlation, investment return and risk is based off historical results and future expectations. If MPT is based off of “what happened” rather than “what will happen”, then the information is only usable to create hypothetically efficient portfolios. Unfortunately as relevant as MPT is to investment planners, it is NOT a “magic bullet”! But there aren’t any real magic bullets in the world of finance, and certainly no “crystal balls”.
While Modern Portfolio Theory can be used to create “yesterday’s perfect balance of risk and investment return”, it is only a tool used to guide us towards tomorrow’s expectation of an efficient portfolio. MPT is, however, based on rational thinking and rooted in solid investment concepts which can and should be used to create a blueprint for your personal investment plan.
Put Modern Portfolio Theory as the basis of your investment strategy. Avoid making random or “ad hoc” investments without any real portfolio purpose. Ground your investment portfolio in the fundamentals and remain committed to your re-balancing program, and you’ll likely provide yourself with the greatest chance for financial and investment success!