Over time, economic and political climates change, causing investors to question their current investment philosophy. We are certainly in one of those environments right now. Investors are asking themselves if the investment strategy they’ve been using is truly the right one for them. Physicians, like all investors, constantly strive to achieve attractive returns in their portfolios and grow their financial assets over time. By accomplishing this feat, investors find that their portfolios, whether earmarked for retirement, college education, or other objectives, can be working for them instead of them needing to work harder to save more. This is especially important in an environment where incomes may be declining.
While the perfect investment would have the attributes of high growth with little or no risk, the reality is these types of investments don’t typically exist. Throughout history, investors have spent significant time developing methods or strategies that come as close as possible to that “perfect investment.” There are many investment strategies, but none is as popular or compelling as Modern Portfolio Theory (MPT).
Developed by Harry Markowitz and published under the title “Portfolio Selection” in the 1952 Journal of Finance, MPT explores how risk-adverse investors construct portfolios to optimize returns in relation to the risk of the underlying investments. The theory measures the benefits of diversification — not having all your investment eggs in one basket. Although developed in the early 1950s, recognition for the achievement was delayed because the task of applying MPT was only made possible using modern computers that could handle the vast number of calculations and range of historical data needed by the model. In 1990, 38 years after he wrote the paper while teaching at the University of Chicago, Markowitz was awarded, along with fellow academicians Merton Miller and William Sharpe, a Nobel Prize for what has become the most widely used strategy for portfolio selection.
For most investors, the “risk” they take in an investment is that the return will be lower than expected. In other words, a deviation from the average return. What they found was, through diversification, the “risk” of one investment may offset the “risk” of another. The key behind the MPT model is determining which combination of investments in a portfolio provide the “maximum return and lowest risk.” Using a tool called the Efficient Frontier, the MPT model looks at desired rates of return and displays the combination of investments that produces the optimal level of return and risk based on past performance of the various investment markets. While the past is not always a predictor of the future, MPT uses this data to estimate various risk/return scenarios.
The key today to utilizing MPT is understanding that different “asset classes” have different levels of risk and combining investments from different asset classes in a measured way gives the investor the greatest probability of achieving their rate of return objectives while minimizing risk as much as possible. Examples of major asset classes include large U.S. companies, small U.S. companies, international companies, domestic bonds, international bonds, and real estate. How well an investor assigns different amounts of their total investment portfolio to these asset classes and how well that distribution across asset classes applies to their investment objectives, is the biggest determinant of long-term investment success. In fact, Markowitz’s study found that over 90% of your long-term investment success is determined by asset class selection.
Funding the various asset classes can be easily accomplished through indexed mutual funds or indexed exchange traded funds (ETFs) that mirror a specific index or asset class. Even after all these years, and a number of bull and bear markets and new investment vehicles, MPT continues to play a crucial and meaningful role in investment management strategy.
Jeff Witz, CFP® welcomes readers’ questions. He can be reached at 800-883-8555 or at email@example.com.
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