What is Modern Portfolio Theory?

Modern portfolio theory has points every retiree should understand

Modern portfolio theory in action.
Modern portfolio theory is good to know; but don't apply it blindly in retirement. JohnLamb/GettyImages

If you recognize the sayings “safety in numbers” and "the law of averages" then you understand the basics behind Modern Portfolio Theory.

Modern Portfolio Theory is a mathematical analysis of a group of investments looked at collectively. It is used to measure the potential return of a portfolio of investments relative to the potential risk in order to determine whether or not the group of investments is giving you "the most bang for your buck."

In practical terms, think about owning shares of a single stock such as General Electric or Enron; you could see price appreciation, or the company could fail miserably and your investment becomes significantly devalued.

Now compare one stock to owning the S&P 500 Index fund (which owns shares in 500 of the largest companies in the U.S.). The index is unlikely to see overnight success or become worthless. By diversifying to this degree, you have reduced the risk of picking the wrong stock.

Modern portfolio theory takes this concept of reducing risk and expands upon it by showing you how one mix of assets might perform over time relative to a different mix of assets. In general, a mix of assets that is expected to have the potential for the highest return over time will also be the mix of assets that has the most risk. Risk is most frequently measured by volatility (ups and downs) over a one year period of time (the technical measurement of risk is called standard deviation).

 

Why Is Modern Portfolio Theory Important?

By following Modern Portfolio Theory, professionals recommend a selection of investments that are designed to provide the greatest return for any given level of investment risk. When Dr. Harry Markowitz introduced this theory in 1952, it was considered to bridge the gap between investment theory and investment selection.

 

Some portfolios will be aggressive and contain riskier stock asset classes, such as small caps and foreign investments. Others are tailored to be more conservative in nature and focus on utilizing investments which counter-balance movements in the stock market, such as fixed income funds or cash.

Over time, greater returns are expected to come from riskier assets, so, if short term risk is acceptable in order to achieve a higher long term return, than a professional will recommend a higher allocation to riskier assets. This process of building portfolios is based on maximizing potential for returns relative to potential for risk.

When you are nearing (or in) retirement, it may be time to change your asset allocation and your investment approach. In retirement it is no longer about maximizing the potential for returns. It is now about securing cash flow for life. When you build a portfolio to solve for maximizing the potential for income for life it leads to a different approach then a portfolio that is build to maximize potential returns per unit of risk. That is why retirement investing needs to be done differently.

Modern portfolio theory in 401(k) plans

Most 401(k) plan choices now offer some form of pre-made portfolios.

Modern portfolio theory is what is used to determine the appropriate asset allocation target in each portfolio. Generally speaking, there may be five to ten portfolio choices available; each will incorporate the use of many mutual funds to achieve the desired allocation and the desired risk/return characteristics. 

Modern Portfolio Theory often goes hand in hand with something called the Efficient Market Hypothesis, which was a key piece of research that was instrumental in promoting the popularity and use of index funds.

The bottom line is that risk-reward expectations are easier to implement, understand, and possibly predict if you learn these practices and follow these philosophies.