How modern portfolio theory can help meet your financial goals

May 28, 2020

"[A study by Harry Markowitz] found that more than 90% of your long-term investment success is determined by asset class selection," writes Jeff Witz, CFP.

Given the market volatility lately, I’m questioning my investment strategy. Is there a preferred approach to follow when investing?

Over time, economic and political climates change, causing investors to question their current investment philosophy. We are certainly in 1 of those environments right now. Physicians, like all investors, constantly strive to achieve attractive returns in their portfolios and grow their financial assets 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 instead of them needing to work harder to save more. This is especially important in an environment where incomes may be declining.

Although the perfect investment would have the attributes of high growth with little or no risk, the reality is these types of investments don’t typically exist. Throughout history, investors have spent significant amounts of time developing methods or strategies that come as close as possible to that “perfect investment.” There are many investment strategies, but none is as popular or compelling as modern portfolio theory (MPT).

Developed by Harry Markowitz and published under the title “Portfolio Selection” in the 1952 Journal of Finance, MPT explores how risk-adverse investors construct portfolios to optimize returns in relation to the risk of the underlying investments. The theory measures the benefits of diversification-not having all your investment eggs in 1 basket.

Although developed in the early 1950s, recognition for the achievement was delayed because the task of applying MPT was only made possible using modern computers that could handle the vast number of calculations and the range of historical data needed by the model. In 1990, 38 years after he wrote the article while teaching at the University of Chicago, Markowitz was awarded, along with fellow academicians Merton Miller and William Sharpe, a Nobel Prize for what has become the most widely used strategy for portfolio selection.

For most investors, the “risk” they take in an investment is that the return will be lower than expected. In other words, it is a deviation from the average return. The MPT model calculated for each investment a “standard deviation” from the mean that the model calls “risk.” What they found was, through diversification, the “risk” of 1 investment may offset the “risk” of another. The key behind the MPT model is determining which combination of investments in a portfolio provides the “maximum return and lowest risk.” Using a tool called the Efficient Frontier, the MPT model looks at desired rates of return and displays the combination of investments that produces the optimal level of return and risk based on past performance of the various investment markets. Although the past is not always a predictor of the future, MPT uses those data to estimate various risk/return scenarios.

The key today to using MPT is understanding that different “asset classes” have different levels of risk and combining investments from different asset classes in a measured way gives the investor the greatest probability of achieving their rate of return objectives while minimizing risk as much as possible. Examples of major asset classes include large US companies, small US companies, international companies, domestic bonds, international bonds, and real estate. How well an investor assigns different amounts of their total investment portfolio to these asset classes and how well that distribution across asset classes applies to their investment objectives, is the biggest determinant of long-term investment success. In fact, Markowitz’s study found that more than 90% of your long-term investment success is determined by asset class selection.

Funding the various asset classes can be easily accomplished through indexed mutual funds or indexed exchange traded funds (ETFs) 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.

 

What is an indexed mutual fund or ETF?

An indexed mutual fund or indexed ETF is a fund that seeks to mimic a particular index. An index such as the S&P 500, which tracks the performance of approximately the 500 largest companies in the United States (large cap asset class), does not actually invest in these companies, nor can you directly invest in the index itself. Therefore, fund companies create mutual funds or ETFs that mimic the index. It invests in the companies contained in the index and in the same percentages the index uses to track performance. By investing in these funds, you can easily invest in an entire asset class. Finding an index fund for each asset class can help you achieve the asset class diversification that is a key pillar to MPT.

The information in this column is designed to be authoritative. The publisher is not engaged in rendering legal, investment, or tax advice.