What is Modern Portfolio Theory (MPT)?
Modern Portfolio Theory examines the performance of a portfolio of assets based on the combination of its components’ risk and return. Based on complex financial economics
and probability and statistical theory, the crucial insight of MPT is that the risk of an individual asset is far less important than the contribution the asset makes to the portfolio’s risk as a whole. It shows that for the same amount of risk, diversification can increase returns. The mechanism to reduce risk is dissimilar price movements. The task is to find assets with low correlations. The Efficient Frontier allows individuals to maximize expected returns for any level of volatility.
What does it mean?
MPT tells us that assets must be evaluated by their effect on the entire portfolio and that diversification reduces risk. For these reasons, we work with Dimensional Fund Advisors (DFA) to uphold the following principles when creating investment portfolios:
Structure Determines Performance:
How assets are allocated across investment classes is of key importance.
Risk and Return are Related:
Increasing exposure to the market, small cap, and value factors is the only way to increase expected returns.
Invest in broad-based portfolios of every asset class where risk is rewarded over the long-term in a strong and documented manner (see Three-Factor Model).
Using Markowitz’s Efficient Frontier, an investor can improve the risk/return trade-off. It is good news for investors to learn that it is possible to either:
increase returns without increasing volatility, or
reduce risk without accepting lower returns.
Because of this, it is important for investors to identify their own risk tolerance level and to understand Matson Money’s four proprietary models:
Income & Growth