Terms Of The Trade: Modern Portfolio Theory

Modern Portfolio Theory (MPT) is an investment theory popularized in a 1952 paper by Harry Markowitz entitled “Portfolio Selection.” The idea behind MPT is that investors should identify and select the lowest-risk allocation for a given expected portfolio return.

While most investors understand on some level that higher market returns inherently correlate with higher risk levels, MPT states that there is an optimal “efficient frontier” allocation that allows investors to maximize returns at a given risk level or minimize risk at a given expected return.

A key part of this theory involves diversification and correlation among investments. If multiple investments are combined efficiently, the net risk of the portfolio will be much lower than the risk associated with each individual investment. By optimizing the combination of risk in a portfolio, you can theoretically reach the portfolio’s efficient frontier.

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Despite the fact that Markowitz’s Nobel Prize-winning paper was published 64 years ago, modern robo-advisors like Betterment and fintech investing apps like Acorn still use MPT principles in their algorithms.

Many of these algorithms perform complicated calculations of co-variance among assets, but every investor can apply the qualitative lessons of MPT to his or her portfolio.

There are a number of places online where you can enter stock and ETF tickers and determine the correlations among different investments. If you diversify your prtfolio by investing in different assets that share minimal correlations, you will certainly be dialing back your portfolio’s overall risk.

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