What is modern portfolio theory?

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What is modern portfolio theory?

You’ve heard the phrase, "No risk, no reward," right? It’s pretty popular. I typed it into Google and got first page results related to HGTV, Final Fantasy XIV, and MMA.

Turns out it also applies to investing (but now I’m questioning my Google search history...).

In fact, there’s an entire school of investment thought built around the idea of risks and rewards – modern portfolio theory (MPT). If you’ve used a robo-advisor platform like Betterment or Wealthfront, you’re familiar with MPT even if you don’t realize it.

But what exactly does it mean for you? Let’s dive into a primer on MPT so you understand what exactly your money is doing behind the scenes.

What is modern portfolio theory?

Modern portfolio theory was started by Harry Markowitz in 1952. It’s become such an integral part of modern investment that it won a Nobel Prize in 1990. MPT determines "how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward."

Basically, how can you construct a financial portfolio that adequately meets your level of risk tolerance? Risk aversion is a major issue when it comes to anything involving finances. It’s why last year, we asked our favorite personal finance bloggers how risk averse they were (you can take our quiz at that link and see how you stack up). Knowing where you stand when it comes to risk tolerance, and knowing how to invest accordingly, can go a long way in making you comfortable with investing.

It’s important to note that MPT doesn’t just apply to an individual investment. It deals with the relationship between your investments – how an investment impacts your entire portfolio. If you’ve ever heard someone talk about diversifying your portfolio, it’s the same idea: make sure everything is working together for a portfolio that fits you.

Terms you should know

Besides the basic definition of modern portfolio theory itself, there are a few other terms you should be aware of to understand MPT:

  • Specific risk – Also called "unsystematic risk" (you’ll see why in a minute).This is the risk of a specific stock. You can lower this risk by increasing and diversifying your investments – essentially the whole point of MPT.

  • Systematic risk – This is risk that’s inherent to investing and can’t be diversified away like specific risk. These are things that are really out of your control, like recessions, interest rates, or other things that inherently affect how we handle money.

  • Efficient frontier – Wealthfront calls this the representation of "the portfolios that generate the maximum return for every level of risk." Essentially, you map out the risk vs. the return on a graph to reveal "desireable portfolios" for various levels of risk/return.

How modern portfolio theory affects your finances

Whether or not you understand it, MPT plays a big role in making your money work for you.

You already know that investing is an important part of your financial future and safety net. Whether you’re actively playing the stock market and trying to beat it (hint: don’t try to do that), putting money into an IRA, or starting a 529 savings plan to send your kid to college, you have to decide how and where you want to invest. Some assets are risky, like stocks, while others, like bonds, are safer bets. Of course, there’s a reason why some assets are safer: they provide less potential for big gains.

Modern portfolio theory is the basis of a lot of modern investing, so it likely affects you in some way if you’re planning for your future, whether it’s education, retirement, or otherwise. This is especially true if you’re using robo-advisors to do that planning.

Betterment and Wealthfront, two of the most popular robo-advisor investment platforms, both have MPT at the heart of their philosophies. Wealthfront has MPT listed in their core methodology, and Betterment includes it as a secret to better performance through the platform. When you sign up to use each platform, you’ll be questioned on how risk tolerant you are. Combined with your investment goals (and some other tricks, like tax-loss harvesting), they tailor their investment options to your risk tolerance level, taking some of the anxiety out of investing.

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Reservations with modern portfolio theory

Of course, every school of thought has its naysayers. There are some people who think that, for various reasons, MPT can be unclear (or even dangerous) for the average investor.

First, some critics think that it makes people take a chance on risky investments that they don’t really understand, like futures. Remember, MPT takes your entire portfolio into account. Therefore, if someone has a group of relatively safe investments, they might offset their portfolio with a complicated investment.

It can also be difficult to choose which investments to include for the average investor. In order for investments to diversify each other, they need to be independent of one another (if assets are following the same trajectory, it defeats the purpose of including both); however, a lot of assets are more interconnected than novice investors think, so they may end up harming themselves by choosing investments that aren’t properly diverse.

Then there’s a question of what exactly is diversity? How many assets should you have to properly accommodate your risk tolerance? That’s a question that even experts argue over, and investors who aren’t in the weeds can become overwhelmed easily.

Of course, one of the main selling points of platforms like Betterment and Wealthfront is that they do all of the MPT-ing for you: robots make the decisions and you make the money.

Don’t take this single article to be the end all, be all of MPT. There’s a lot more to it than what we’ve explained here (check out the MPT Wikipedia page for some Beautiful Mind-style high-level mathematical models). But this should at least give you a basic understanding of how you can start your investment journey with MPT, and what happens to your money when you invest it.