Calculate risk/return with this time-tested strategy

April 15, 2015

Although significant time is spent developing methods or strategies that come close to that “perfect investment," none is as popular or compelling as modern portfolio theory.

With all of the issues facing both our domestic and global economies, how can anyone prepare a successful investment plan?

Over time, economic and political climates change, causing investors to question their current investment philosophy. Physicians, like all investors, constantly strive to achieve attractive returns on their portfolios in order to have their financial assets grow over time. By accomplishing this feat, investors find that their portfolios, whether earmarked for retirement, college education, or other objectives, can be working for them as opposed to them working harder to save more, in an oftentimes declining income environment.

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While the perfect investment would have the attributes of high growth with little or no risk, the reality of course is quite different. Not surprisingly, significant time is spent developing methods or strategies that come close to that “perfect investment.” None is as popular or compelling as modern portfolio theory (MPT).

Developed by Harry Markowitz, PhD, and published under the title “Portfolio Selection” in The Journal of Finance (1952; 7:77-91), MPT explores how risk-adverse investors construct portfolios in order to optimize market risk against expected returns. The theory quantifies the benefits of diversification-not having all of your investment eggs in one basket. In 1990, 38 years after he wrote the paper while teaching at the University of Chicago, Dr. Markowitz was awarded, along with fellow academicians Merton Miller, PhD, MA, and William Sharpe, PhD, MA, a Nobel Prize for what has become the most widely used strategy for portfolio selection.

Although developed in the early 1950s, recognition for the achievement was delayed because the task of applying MPT was only made possible by the use of modern computers that could handle the vast number of calculations and range of historical data needed by the model. Portfolio management today combines theory and technology in order to optimize portfolio performance.

For most investors, the “risk” they take in an investment is that the return will be lower than expected. In other words, it is the deviation from the average return. The MPT model calculated for each investment a “standard deviation” from the mean that the model calls “risk.” Through diversification, the “risk” of one investment may offset the “risk” of another.

NEXT: Plotting the 'efficient frontier'

 

The key behind the MPT model is the plotting of an “efficient frontier” of the varying combinations of investments in a portfolio that provide the “maximum return and lowest risk.” For every point along the efficient frontier, the MPT model displays the combination of investments that produces the optimal level of return and risk based on past performance of the various investment markets. While the past is not always a predictor of the future, MPT uses this data to estimate various risk/return scenarios.

The key today to the utilization of MPT is understanding that a variety of “asset classes” provides diversification and quantifies the risk and reward of any given portfolio. Examples of major asset classes include large U.S. companies, small U.S. companies, international companies, domestic bonds, international bonds, and real estate. Understanding the various asset classes and their respective indices leads to the construction of a portfolio that can still encompass the historical validity of MPT.

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Funding the various asset classes can be easily accomplished through mutual funds or exchange-traded funds that mirror a specific index or asset class. Even after all these years, and a number of bull and bear markets and new investment vehicles, MPT continues to play a crucial and meaningful role in investment management strategy.

NEXT: How does interest rate changes affect bonds?                                                                     

 

How does interest rate changes affect bonds?                                                                       

Bonds carry “market risk.” As interest rates rise, the value of an existing bond decreases, because it pays a fixed rate of interest that would be lower than what is being offered in the market. On the other hand, bond values appreciate when interest rates decline. The longer the maturity time frame, the more sensitive the bond is to interest rate changes.

Other risks that impact bond pricing include “credit risk,” which rating agencies define as the ability of the issuer to pay back interest as well as principal. With a higher risk bond, a greater amount of interest would be promised as opposed to bonds with a high credit rating, which pay a lower amount of interest to their investors. Beyond market and credit risk, there is also the risk that the issuer will “call” the bond prior to maturity at a pre-stated value. This typically happens as interest rates fall, and the issuer can “refinance” or offer new bonds at a lower rate.

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