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What Is Modern Portfolio Theory?

Wayne Duggan

In the world of Wall Street, 60 years is an eternity. So when a concept like modern portfolio theory remains one of the most popular and successful investing strategies 66 years after it was first published, it's probably a good idea for investors to understand how it works.

Modern portfolio theory was published by Harry Markowitz in the Journal of Finance in 1952. Markowitz was not the first person to appreciate the power of diversification, but his modern portfolio theory was the first system that quantified the best method of constructing a portfolio based on a given risk level.

Markowitz's idea, for which he was awarded a Nobel Prize for economics in 1990, was that investors should carefully select the lowest-risk allocation for their portfolios based on specific targeted returns.

The basic principle of diversification involves creating a portfolio of multiple investments to limit the overall risk any one investment poses to the portfolio. The more unique that stocks and other assets an investor owns are, the less risk each one poses to the portfolio. In addition, the less correlated each asset is to the others, the less net risk the portfolio has overall. At the core of modern portfolio theory is the idea of an optimal "efficient frontier," or a point of maximum expected returns for any given risk level.

[See: 7 of the Best Blue-Chip Stocks to Buy for 2018.]

Diversification isn't just about buying dozens of different stocks and exchange-traded funds. Owning two different exchange-traded funds that are highly correlated with each other can be nearly as risky as owning just one of them. For example, the SPDR S&P 500 ETF Trust (ticker: SPY) and the SPDR Dow Jones Industrial Average ETF ( DIA) have nearly a perfect correlation with one another, so owning both in the same portfolio doesn't do much to improve diversification and limit risk.

However, the SPDR Nuveen Barclay's Capital Municipal Bond ETF ( TFI) has little correlation with the SPY ETF. By owning both ETFs, an investor can reduce the combined risk in the portfolio to well below the individual risk levels associated with each ETF.

Owning a portfolio of five tech stocks is less risky than owning just one tech stock. Owning a portfolio of five stocks from different sectors of the market is even less risky because the stocks will typically have lower correlations among them. The correlations within the hypothetical portfolio fall even lower if an investor includes international stocks, bonds, commodities, real estate and other diverse assets.

By considering and optimizing correlations among different stocks, ETFs and asset classes, investors can theoretically reach a portfolio's efficient frontier. The power of diversification allows investors to theoretically reduce the risk of a portfolio while preserving its potential return.

Modern portfolio theory incorporates a number of correlation and risk metrics, including alpha, beta, standard deviation, R-squared and Sharpe ratio. Fortunately, the average investor doesn't need to calculate or even use these metrics to understand the general idea that diversification and correlation are important in minimizing risk.

[See: 10 Great Ways to Buy Tech Stocks.]

But with modern investing technology and strategies seemingly changing on a daily basis, just how useful is a 60-year-old hypothesis to today's investor? Most financial experts agree that the principles are timeless.

"It is a tried-and-true classic, and is extremely relevant for long-term investors today," says Mike Loewengart, vice president of investment strategy at E-Trade. "Risk and reward go hand-in-hand, which means those brave souls who can stomach more risk have an opportunity to see more outsize returns, but can also, of course, get wiped out."

Joe Heider, president of Cirrus Wealth Management, says following the principles of modern portfolio theory can help safeguard investors from falling victim to emotion.

"Modern portfolio theory continues to be important and relevant for the long-term investor," Heider says. It helps the investor hold fast to a strategy rather than get carried away with market hype.

Owen Murray, director of investments for Horizon Advisors, says modern portfolio theory is a how-to guide for minimizing portfolio risk.

[See: These 7 Funds Make You Feel Good About Investing.]

"For most, the diversification modern portfolio theory requires is essential to achieving the long-term returns necessary to achieve their financial goals," Murray says. "Placing too much of your retirement nest egg in any one stock exposes your portfolio to the potential for a catastrophic loss."

Fortunately for inexperienced investors, many financial advisors and even popular robo advisors incorporate elements of modern portfolio theory in their allocation strategies to this day. The rise of ETFs and mutual funds has made diversification easier and cheaper than ever, so there's no excuse for long-term investors to take unnecessary risks with their hard-earned cash.

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