Let’s say you invested all of your money in a single stock. It might work out great if, for example, you bought Apple or Coca-Cola decades ago and just held on. But it would’ve been a pretty bumpy ride. And if you needed to cash out during one of the many periods when those stocks were down -- or if you had chosen Enron or Pets.com instead -- well, that’d be a completely different story.
Win or lose and regardless of what stock you pick, if you only pick one (or a few), what you’re doing is not investing -- it’s betting. And that’s the riskiest of all possible ways to manage your money
Play Each Card Right
We’re not saying that individual stocks (and equity mutual funds and Exchange Traded Funds (ETFs)) have no place in a portfolio. Despite their inherent risks, they are, in fact, an essential ingredient to achieving higher long-term returns versus all of the less-risky-yet-lower-return asset classes.
But when smart investors see a stock or fund that they think has promise, they don’t make a decision to buy or sell it in a vacuum: They step back for a broader view and evaluate its merit based on what the investment brings to the overall portfolio -- both its expected return as well as how much risk exposure it brings.
This is where Modern Portfolio Theory -- and its predecessor, Portfolio Theory -- comes in. Portfolio Theory was a mathematical modeling formula for finance introduced in 1952 by economist Harry Markowitz. Markowitz studied the effect of asset risk, return and diversification in order to find the best possible diversification strategy for investors.
His findings have been enormously impactful in shaping the thinking behind how people construct portfolios, and in 1990 he was awarded the Nobel Memorial Prize in Economic Sciences for his work. In 2013 Eugene Fama won the same honor for research based on Markowitz’s work that laid the foundation for the strategy we now call Modern Portfolio Theory.
Diversification on Steroids
Calling Modern Portfolio Theory (MPT) a simple diversification strategy belies the underlying theory’s complexity and critical role in building better portfolios.
Instead of simply spreading money across different types of investments, it’s about picking the right combination of assets -- looking at how an asset’s risk compares to every other investment in the portfolio on a relative basis.
This is important because it has been shown that in certain market conditions assets that are supposed to move in opposite directions as a reaction to certain outside influences can actually start to mimic each other, therefore exposing investors to more risk than they might otherwise assume. At the same time, MPT helps mitigate against market risks that affect all asset classes, such as wars, recessions and economic busts.
Because of MPT’s aim to maximize returns with the least amount of exposure to volatility and risk, it has become a key tool for the world’s leading investors to help them construct portfolios that can withstand many market conditions.
Like any theory, Modern Portfolio Theory is not perfect. Much emphasis is made on historical correlations, which aren't always that reliable in predicting future correlations. That's why at FutureAdvisor we also consider different economic scenarios and how they might impact investments, even if those scenarios haven't been particularly common in the recent past.
If you'd like to see how FutureAdvisor puts Modern Portfolio Theory into practice, you can get your own personalized portfolio in under 2 minutes - for free.
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