Modern Portfolio Theory: Building A Well-Diversified Portfolio

by Todd Smith on November 30, 2010

I take a skeptical stance in many investment situations. And, I must admit that more often than not, I claim that most investment strategies are futile. I may dismiss some of the most alluring products as marketing jargon or public misleads. But, it’s not because I am a perpetual skeptic or a doomsday pessimist by nature. Rather, it’s because my general investment philosophy boils down to the major tenets of Modern Portfolio Theory (MPT).

Understanding Modern Portfolio Theory

Naturally, having been trained in the field of portfolio construction and management, I share the concept of MPT with the majority of the financial industry. Modern Portfolio Theory is a theory of investment that attempts to maximize return and minimize risk through the selection of different asset classes. Diversification and proper asset allocation were born from a mathematical equation that shows that a combination of different assets has a lower, combined risk than an individual security. When combined, non-correlated assets create a portfolio with lower risk and maximized returns. For example, stocks and real estate typically are not strongly correlated. That means that they will tend to behave differently under different economic circumstances and should, when combined, minimize the overall volatility of a portfolio.

Understanding the general concept of Modern Portfolio Theory is important because not all assets in a diversified portfolio will perform in the same way. While some assets might be doing well, others may not. Personally, that’s where I think many investors go wrong. Of course, no one likes to see any of their assets lose money or underperform, but people do want their assets to perform differently. Unfortunately, this implies that some assets will underperform other investments. Sometimes, non-correlated assets will perform very similarly, and sometimes that means multiple non-correlated assets will react positively at the same time. But, keep in mind that this is not the norm. If your assets are moving in tandem (up and down), then they are strongly correlated and you probably are not adequately diversified. This is not the best financial strategy to protect your assets from financial loss.

A Typical Example of Investor Behavior

An investor looks at her portfolio and realizes that her large cap mutual funds have performed extremely well over the last year, her international stock funds have lost money, and her bond funds have barely held their own. What is her natural response? Most likely, she will sell off her international funds, moving them into the large cap mutual funds. She will probably also think about what to do with her bonds since they are not doing anything for her either. Maybe you don’t see my logic here, but this behavior goes against the major concept of Modern Portfolio Theory. You WANT assets that are different. If your portfolio has been constructed properly, everything has a purpose — including bonds, assets that may be losing money, and even money market accounts that pay you hardly anything.

Three Cardinal Sins of Investment

By selling her underperforming assets and moving them into her best performing assets, our typical investor above is charged with three cardinal investment sins:

1. Reducing Diversification
If her assets are performing differently because of low correlation, selling one to load up on another will reduce her diversification and maximize her risk — with no promise of anything extra in return.

2. Buying High and Selling Low
She is, in essence, selling low and buying high. Hmmm…what about buying low and selling high? She is selling her underperforming assets when their prices are lower and when they have lost money. Then to make matters worse, she is purchasing her pricier assets while they’re trending higher. The reality is this: it’s difficult to make money on an investment after it’s already had a significant run up.

3. Timing the Market
Without realizing it, she is trying to time the market. She may not be a day trader or consider herself a market timer; however, she is trying to figure out when to hold one asset and unload the other. That’s very hard to do. Due to the vast rotation of assets (coming in and out of favor), she probably has missed the party already, by moving into an asset class that’s already peaking or topping out. Odds are that the best performing class will no longer hold its position in the following year. So, where does this leave our investor? Chasing returns from one class to the next…. Now she may get lucky, but most of the time she will only be increasing her risk by selling low and buying high. Most likely, she is also adding to her investment fees and stress. This is not a good position to be in.

Successful Investing Using The Modern Portfolio Theory

I always joke that investment market behavior is bipolar: blissful when things are good and unreasonably depressed when things go badly. Either way, this leads many investors to make irrational and emotional decisions — such as selling assets that are underperforming. That’s where a professional can really earn his or her keep. More than trying to pick “winners” for us, oftentimes they can help us settle down and protect us from ourselves and the impulsive decisions we could end up making.

Successful investors can typically weather the volatility in markets because they understand and adhere to the Modern Portfolio Theory. These investors stick to well diversified investments and balanced portfolios. They know that different assets come in and out of favor frequently. More importantly, they know that not all of their asset classes will do well all of the time. And, they are okay with that. Why? Because their portfolio as a WHOLE provides decent returns with a lot less risk, guess work, and stress. They are not trying to guess where to invest at any given time. They stick to a long-term tactical asset allocation model that works well for them in the long run.

If you enjoyed this post, you can get free regular updates through our RSS Feed, or you can have our latest posts delivered to your email inbox by supplying your address here. Your address will only be used for this purpose, and you can unsubscribe anytime.

{ 0 comments… add one now }

Leave a Comment