Modern Portfolio Theory and Asset Class Investing
By Chris Nolt
In this article, I will explain Modern Portfolio Theory and asset class investing and how these investment approaches can be implemented.
In 1990, Harry Markowitz, William Sharpe and the late Merton Miller won the Nobel Prize for economics for their research on creating investment portfolios. They developed a mathematically optimal portfolio. Based on a study of historical investment performance, they recreated the best combination of securities in a portfolio.
Markowitz called this mathematically correct portfolio an efficient portfolio. His method sought to achieve maximum returns with the least amount of risk and volatility as measured by standard deviation. Standard deviation is a statistical measurement of the variations in return.
The scientific system Markowitz pioneered – and which won the Nobel Prize – came to be known as Modern Portfolio Theory. This investment strategy is now accepted worldwide as the authoritative blueprint for prudent investing.
The five key concepts of Modern Portfolio Theory are 1.) utilizing diversification effectively to reduce risk, 2.) dissimilar price movement diversification enhances return, 3.) employ asset class investing, 4.) global diversification reduces risk and 5.) design portfolios efficient portfolios.
Utilize diversification effectively
Most of us understand the basic concept of diversification – don’t put all of your eggs in one basket. However, many investors are not effectively diversified.
Ineffective diversification, for example, involves being invested in mutual funds, which exhibit similar patterns of performance. Effective diversification combines multiple asset classes with different patterns of performance.
The overall risk of a portfolio is not the average risk of each of the investments. Rather, the overall risk is actually less than the average risk if investments do not move together.
Dissimilar price movement diversification protects people from having all their investments go down at the same time.
Price movement diversification
If one has two investment portfolios with the same average or arithmetic return, the portfolio with less volatility will have a greater compound or geometric rate of return.
For example, let’s assume someone to be considering two mutual funds. Each of them has an average annual expected return of 10 percent. How can one determine which fund is better?
They would expect them to have the same ending wealth value. However, this is only true if they have the same degree of volatility, as measured by standard deviation.
If one fund is more volatile than the other, their compound return and ending values will be different. It is a mathematical fact the fund with less volatility will have a greater compound return.
Asset class investing
Most investors who understand the first two concepts use conventional, actively managed mutual funds to implement them. This is like trying to fix a sink with a screwdriver, when a pipe wrench is actually needed.
In other words, use the right tools. Index funds and asset class mutual funds are the right tools.
In 1970, the international equity market represented only 32 percent of total world equities. Today, approximately half of the public traded securities are overseas.
In building portfolios, one should consider the diversification opportunities available in the international markets. Global diversification is designed to help protect investors from an unexpected downturn in any one country’s market.
Another reason for global diversification is that historically, foreign markets and asset classes within those markets have not moved in unison. Adding international exposure to a portfolio can decrease the standard deviation of the portfolio.
How do we decide which investments to own and in what combinations? The Efficient Frontier is one of the core concepts of Modern Portfolio Theory and it can be used to answer this question.
It represents a theoretical line connecting all portfolios, which provide the investor with the highest expected return for his or her chosen level of risk. The efficient frontier is determined by calculating the expected rate of return, standard deviation and correlation coefficient for each asset class, and using this information to find the range of portfolios with the highest expected return for any given level of risk.
Most investors’ portfolios fall significantly below the efficient frontier. Even a portfolio such as the S&P 500, which is often used as a proxy for the U.S. market, falls below the line of the efficient frontier because it is possible to create portfolios that have produced higher returns than the S&P 500 for the same amount of risk.
Chris Nolt is an independent, fee-only registered investment advisor and the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC, sister companies dedicated to working with families around the country who are selling a farm or ranch and transitioning into retirement. To order a copy of Chris’s new book, “Financial Strategies for Selling a Farm or Ranch,” visit amazon.com or call Chris at 800-517-1031. For more information, visit solidrockproperty.com and solidrockwealth.com.