Q: What is modern portfolio theory?
A: It's the award-winning idea that it's better to have a diversified investment portfolio than to hand-pick stocks.
So, what is it exactly? In the 1950s, a guy named Harry Markowitz won a Nobel Prize for figuring out how to manage your retirement account. That’s an oversimplification, of course, but what you need to know is that a great deal of what governs the advice almost all financial advisors give comes from the work of this man.
Before modern portfolio theory was developed, the operating principle of investing was to look at individual stocks and find “winners”—equities that would produce decent returns without too much risk. The problem was that individual stocks are risky by nature. This new theory said that what investors should seek instead is diversification. That way, you bet on bigger slices of the economy and take advantage of “winners” you might not have thought of, while protecting yourself against unforeseen disasters.
Modern portfolio theory has a basic aim that by now probably sounds familiar: minimize volatility (risk) and maximize reward (money!) by finding a combination of stocks that won’t have wild swings in value but will provide decent returns.
What are the pros? The first advantage is that this approach tends to manage risk well. You’re investing in lots of stocks, which helps diversify your portfolio. The stocks are also selected to be balanced. For instance, modern portfolio theory argues against investing in equities that are dependent on each other—say, energy stocks and the automobile industry—instead, it preaches investment in things that are not correlated, like oil and the technology sector.
By trading off a bit of risk, optimized portfolios gain reward.
Is there anything to be careful about?
Not understanding the reasoning behind what you’re doing is the biggest risk involved with trying to implement modern portfolio theory. People who wake up one day and say, “I’m going to create the perfectly optimized portfolio!” without knowing what they’re doing or understanding the math behind it will likely fail. Also, because the data used to calculate the perfect portfolio is based on past performance, there is no guarantee that it will yield the same results in the future.