What is Modern Portfolio Theory? And What It Means For You.
Updated: Jul 10, 2022
What Is the Modern Portfolio Theory (MPT)?
When we say that OnlyFunds uses MPT to select its investments, that is a simple way of saying that we are trying to maximize the return of a portfolio with a given risk target or minimize the risk of a portfolio for a targeted return.
This theory, introduced by Nobel Prize winning economist Harry Markowitz, guides almost all modern portfolio construction.
The concept is relatively simple: if you put together a bunch of assets that do well at different times and do poorly at different times, the success of the overall portfolio will be better than a portfolio with concentrated risk.
Take, for example, someone who puts 50% of their money into real estate and 50% of their money into the US stock market. That may seem diversified, but think about what the risks are. If the economy does poorly, the value of the stocks will surely go down. If the economy is doing poorly, though, the value of real estate may behave similarly.
We'd say in this example that real estate and stocks are highly correlated, meaning the behave similarly in different environments. This is bad for the overall portfolio.
Now imagine you had 20% in bonds, 20% in US stocks, 20% in European and Asian stocks, 20% in real estate, and 20% in gold. This portfolio is much more diversified. In environments when the economy is doing well, the stocks and real estate may take the lead. If the economy is not doing well, bonds and gold may perform well. If inflation becomes a worry, stocks and bonds may do poorly, but gold and real estate should outperform. Its all about balance, and doing so optimally.
What does this mean for me?
MPT argues that any given investment's risk and return characteristics should not be viewed alone but should be evaluated by how it affects the overall portfolio's risk and return. That is, an investor can construct a portfolio of multiple assets that will result in greater returns without a higher level of risk.
An important part of this is not thinking of one account as "my portfolio", but the entire set of assets you own. You should have good diversification across all your accounts, retirement, savings, housing, and maybe even where you work.
It also means that you should rebalance your portfolio to stay diversified. After one or two asset classes are done taking their turn outperforming, the environment may shift. It pays to always be ready!
How does OnlyFunds make use of MPT?
The MPT is a useful tool for investors who are trying to build diversified portfolios. In fact, the growth of exchange-traded funds (ETFs) made the MPT more relevant by giving investors easier access to a broader range of asset classes.
OnlyFunds looks through thousands of ETFs of different asset types (think stocks, bonds, gold, etc in the example) and puts them together in portfolios that try and maximize your return. After we ask you questions about your financial goals and how long you have to reach them, we assign you to a risk level. From that risk level, we try to maximize the money you make.
On top of all that, we automatically rebalance your portfolio so you stay ready to take advantage of any market.
Convinced of the benefits of MPT? You can open an account for free in less than 5 minutes, with a $0 minimum deposit.