Modern Portfolio Theory

by | Portfolio Management

Modern Portfolio Theory was developed in the 1950’s with the belief that portfolio returns could be maximized for a given amount of investment risk by combining assets in a particular manner. The theory is that, using relationships between risk and return such as alpha and beta, and defining risk as the standard deviation of return, an “efficient frontier” for investing can be identified and exploited for maximum gain at a given amount of risk.

Much of Modern Portfolio Theory is now questioned. So why should you care? Why learn about something that is not 100% accepted as fact? The reason you should care is the principles and theories are foundations for building sound portfolio management strategies.  There is no “perfect” model. Those who believe they have perfect models find out that markets change, correlations change, people change, business changes; you get the idea.

Practice and Theory in Modern Portfolio Theory

What have we learned from Modern Portfolio Theory?

Proper asset allocation works by reducing portfolio volatility and/or increasing long term returns when non-correlated asset categories are combined.

Proper investment diversification of individual investment choices reduce volatility risk by nearly eliminating specific or unsystematic risk.

Standard deviation provides a credible model for understanding the probability of outcomes far away from the mean (average).

Modern Portfolio Theory concepts such as Alpha and Beta, Standard Deviation, the Sharpe ratio, Capital Asset Pricing Model (CAPM), Regression, and R-squared have provided a foundation for debate that has continued to provide additional insight into the relationship between investment risk and returns.

How to Use Investment Portfolio Theory

One of the first lessons that should be learned from Modern Portfolio Theory is to not have too much faith in any model. Nothing is a sure bet; that is why it is called investment risk! Modern Portfolio Theory provides a foundation for learning and developing good practice from portfolio management concepts.

Use investment portfolio theory to build your own foundation of beliefs and strategies for sound investing. Don’t buy into “trading systems” or theories that offer rewards that are too good to be true; because they will be too good to be true. Even the best and brightest believed they had theories that would stand the test of time; only to be proven wrong over time.

Investment Risk and Returns

We have learned the importance of investment risk and explored some of the portfolio management concepts to measure and mitigate risk when possible. Nobody will be right all the time; but we can greatly increase our chances to succeed by accepting only prudent risks.

The successful investor will take these investing concepts and portfolio management concepts to build discipline and employ investing strategies with high probabilities to succeed. Risk management and proper diversification will improve your portfolio rates of return
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The Arbor Investment Planner website offers a wide variety of resources pertaining to wise conservative investing. We only want to take those risks where the odds are heavily in our favor. I can help you make wise decisions through this blog and/or my membership services.

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Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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