Less Risk May Lead to Higher Returns – Understanding Modern Portfolio Theory
Traditional thinking may lead a person to believe that there is a direct correlation in the amount of risk or volatility an investment portfolio is exposed to and potential return on those investments. Modern Portfolio Theory is the widely accepted theory that a diversified portfolio with investments in a variety of asset classes can be constructed to reduce overall risk and experience higher returns in the long-term.
Modern Portfolio Theory (MPT)
Prior to the 1950s, investment strategy was largely based on the Dividend Discount Model and was pretty simple. Perhaps over simplifying the model, the idea was to find a stock and buy it at the best price. Investment strategy had something of a renaissance when, in 1952, Harry Markowitz published Portfolio Selection in the Journal of Finance. Portfolio Selection evolved into the Modern Portfolio Theory.
MPT is a theory of finance that attempts to maximize the return on a portfolio of investments for a given amount of risk. MPT applies a mathematical equation to the diversification of a portfolio in an effort to assemble a mix of assets that have less risk as a group than any one of the individual assets. A diverse portfolio is set up to minimize overall risk and maximize long-term returns. MPT was so widely accepted that in 1990 it earned Markowitz the Nobel Prize in Economic Sciences.
Diversity Leads to Less Volatility
The key to a diversified portfolio is choosing an optimal mix of investments that do not tend to perform the same in given market conditions. When one asset class is under-performing, you are likely to be invested in other asset classes that are out-performing expectations. This type of negative correlation helps the gains offset the losses. A diversified portfolio therefore will protect against the high risk or volatility of being invested in any single asset class.
Diversified Portfolios Typically Perform Better in the Long-Term
The graphic below provided by Curian Capital LLC compares three hypothetical portfolios with the same annual average return. The graphic demonstrates that the consistency of performance over time will typically provide better long-term results. Portfolio A in this hypothetical example is the least volatile or risky of the three portfolios yet it creates a significantly higher actual dollar return over the 20-year life of the investment.
Establishing a balanced portfolio may reduce your overall exposure to volatility and provide you the best returns over time. A diversified portfolio does not remove risk and there is no guarantee against losses. Even experienced and savvy investors turn to professionals for help in creating a portfolio that minimizes their risk and increases their likelihood for investment gains.