Introduction to Modern Portfolio Theory

The key principle you must understand to have a well-balanced portfolio is modern portfolio theory.

Although the idea was introduced in 1952 by Harry Markowitz (who got a Nobel for it), it still doesn’t get the central focus it deserves in investment planning. Like the efficient market hypothesis introduced by Friedrich Hayek seven years earlier (who also got a Nobel for it), it is a very useful theoretical model to understand the relationship between investment risk and performance, but should not be abused by failing to question whether its underlying assumptions hold true in particular cases.

Let me try to explain the basic idea of MPT with a simple example:

Suppose you want to start investing with $100. You could choose to put all $100 in Apple’s stock. Your portfolio will then depend entirely on how Apple performs in the future. It’s done great in the past, so it might continue to gain value, or the iPhone 8 might be a disaster, and you will lose everything. Investing in any single company is a high-risk investment because you’re putting all your eggs in one basket.

If you wanted a safer portfolio, you could put $50 into Apple and $50 into Amazon. Now you have a similar expected return, but much less risk. However, the fortunes of Apple and Amazon are still highly correlated because they are both tech stocks, and they tend to move up and down together. If the tech market crashes, you will still lose a lot of money.

What you could do is put half your money into Exxon, which is less likely to match the performance of tech stocks, and so will provide similar returns with a lot less risk. You could take this strategy further and split your $100 into 25 different stocks in all kind of sectors such as industrials, healthcare, and utilities, and include some international stocks as well. You might put some of your money into bonds, which are much safer (you only lose your money if the company or government goes bankrupt), but provide a lower return.

Here’s the key insight of MPT: you can graph all possible allocations of a set of investments on an efficient frontier: a line (actually a hyperbola) which represents a combination of investments that has the least risk for a given level of return. From a safe 100% bonds portfolio to a risky 100% stock portfolio, every point on the frontier represents the highest return for a given level of risk. The degree of risk you’re willing to tolerate depends on your personal preference, but you should always try to maximize your return for whatever risk tolerance you choose. You achieve that by having a well-diversified portfolio where no single asset represents more then 4% of the total, and the correlation between assets is minimized.

Here is another insight of MPT: you can often lower your risk with a small degree of diversification. By putting 25% of a portfolio into international stocks, a little in alternatives such as real estate, and a little in bonds, you greatly lower the risk, with only a slight decrease in the expected return.

Below, I show you exactly what this looks like for my portfolio.

The catch is that the efficient frontier is based entirely on historical performance, so if the market behaves dramatically different than it has in the last 100+ years, your assumptions won’t hold true. Furthermore, it is not a set-it-and-forget-it approach: you must continually update the model based on market performance and re-balance your portfolio to keep the ideal asset allocation. This is a lot of work! In fact, it’s more work than the average investor is capable of, which is why I don’t recommend that individual investors buy individual stocks. Instead, you should either buy a few ETFs which represent entire markets, or let a robo-trader do it for you. The ETF approach could consist of just three securities: a domestic market ETF, an international market, and a bond ETF. A robo-advisor would do the same thing, only more efficiently (so less risk, lower taxes, and potentially higher returns), but for a small fee. (I use Personal Capital, but is cheaper for new investors.)

Here’s what an efficient portfolio looks like for me. If you own stocks or a 401K, etc, I suggest you sign up for the the free Personal Capital app, so you can see whether your portfolio is efficient.