Modern Portfolio Theory 101

Monday, September 14, 2020 | Leave a comment

By Darrell Bryant

The financial world can sometimes include a confusing alphabet soup of acronyms. Today we’re going to talk about MPT, which stands for modern portfolio theory. MPT is a popular approach to modern investing, and the goal of MPT is to maximize returns for a given level of risk or try to minimize risk for a given level of returns. There are certain principles that MPT is based on. First, greater risk brings greater potential return. Second, the overall portfolio is more important than any individual security. Finally, constructing a portfolio of unrelated, uncorrelated assets reduces risk. While these principles may not hold true in every scenario (very few principles in investing do), they may help achieve the goals of MPT in most situations. Allow me to discuss in more detail. 

Greater Risk Brings Greater Potential Return

Generally, risk and returns move hand-in-hand. If you want the potential for greater returns, you likely have to take on greater risk. Treasury bills are a very safe investment, but they provide a minimal return. Riskier securities have to provide a higher return, otherwise, no one would invest in them. If all returns were the same, then everyone would use the safest investments. 

The same thing can be viewed from the opposite perspective. If you don’t want to take on risk, then you likely will not be able to achieve some of the highest returns. You may limit your potential gains by the amount of risk you are willing to take on. 

The Portfolio Is More Important Than The Individual Security

Modern portfolio theory seeks to maximize returns for a given level of risk or minimize risk for a given level of returns. However, when looking at risk, MPT doesn’t look at individual securities. MPT looks at the bigger picture of the entire investment portfolio. It isn’t necessary to minimize risk or maximize returns for every individual security as long as the overall portfolio collectively meets your objectives.

Unrelated Assets Reduce Risk

An MPT portfolio is optimized through the use of unrelated assets that are not correlated. Instead of investing all in large American companies that gain and lose value in tandem, an MPT portfolio would have more variety. 

For example, a gold ETF might be paired with an S&P 500 ETF since usually gold goes up when the S&P 500 goes down. That way, when one investment is going down, the other acts as a buoy to balance out the overall portfolio. By having the right combination of assets that counterbalance each other and move independently of one another, an MPT portfolio can optimize returns while minimizing risk.

How We Can Help

We at D. Bryant Retirement Strategies ascribe to modern portfolio theory. We help our clients set up a broadly diversified portfolio with a comfortable risk level. Our investment managers do their best to make sure that our clients are not taking on any unnecessary risk for the returns they are earning and are not earning subpar returns for the amount of risk that they carry. 

2020’s market volatility has caused many investors to reevaluate the level of risk with which they are comfortable. During an 11-year bull market, it was easy to say that you had a certain risk tolerance; but when the market dropped, our emotions likely betrayed the truth. If you’ve recently found yourself questioning your portfolio and risk tolerance level, now is a good time to get a second opinion from a trained professional. To get in touch, call us at (402) 932-2141 or email contact@dbretirement.com.

About Darrell

Darrell Bryant, CFS®, CAS® is Omaha’s Retirement Strategist. As the founder of D. Bryant Retirement Strategies, he focuses on helping individuals and couples nearing retirement do so successfully. Along with more than 30 years of experience, he received the Certified Fund Specialist (CFS®) designation and a Certified Annuity Specialist (CAS®) designation from the Institute of Business & Finance. Passionate about helping as many people as possible in his community, he hosts Retirement Strategies Radio, heard Saturday mornings at 8:00 a.m. on 1110 KFAB. He has also written articles on financial planning that have been featured on Fortune.com, FoxBusiness.com, Money.com, and in the Midland Business Journal. To learn more, visit his blog, his website, or connect with him on LinkedIn.

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