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A Guide to Modern Portfolio Theory

According to modern portfolio theory, there are three rules to be followed to make an investor earn more money with less risk during long periods.

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Modern portfolio theory (MPT) is a fundamental wealth management strategy that won the Nobel Prize in economics in 1990. There are three components of MPT:

  1. Pick a fully diversified portfolio—meaning stocks and bonds, U.S. and foreign, small and large companies, etc.
  2. Implement your portfolio with diversified, low-cost investments.
  3. Rebalance the portfolio on a regular basis.

As straightforward as it sounds, sticking with this strategy can be difficult since an investor is never completely concentrated where things are doing best. While an investor owns top performing assets, they will also own the asset class doing the most poorly. This is due to the full portfolio diversification.

MPT states there are three rules to be followed to make an investor earn more money with less risk during long periods.

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Rule 1—Pick the Right Mix

Thankfully, picking the right mix is extremely loose, as certain people can prefer higher concentrations in certain types of investments. The most difficult factor of this allocation is the need to maintain consistency throughout time, not shifting around chasing hot sectors of the market.

Rule 2—Implement Low Cost

Implementing a low-cost, diversified portfolio is easier these days, as it can be done through low-cost index funds. There are a few nuances, but many people are increasingly aware of MPT when constructing their portfolios.

Rule 3—Rebalance

The final step, rebalancing on a standardized basis, is where much of the benefit occurs. When rebalancing to one standard allocation, certain sectors of the investment world are increasing in value and others will do poorly on a relative basis. This means your initial diversification between various asset classes will morph through time unless kept rebalanced. Thinking through what this entails, you are selling a bit of what has done the best and buying a bit of what hasn’t done well. This may seem counterintuitive but ends up helping investors sell high and buy low over time. Rebalancing when things reach a certain threshold of unbalanced is a good course of action, but other methods are also effective if defined in advance and consistently implemented.

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A Modern Portfolio Theory Example

Still confused? Think of it this way—a typical retiree may have a portfolio resembling the following:

  • 40 percent bonds;
  • 30 percent large U.S. companies;
  • 10 percent small U.S. companies; and
  • 20 percent foreign companies.

Each category has a corresponding market index, but indexes cannot be directly invested in. Investment advisors help determine a cost efficient and diversified method to fill these categories and implement strategy.

Once everything is set up, little attention is needed other than annual rebalancing or if a drastic shift occurs. If a drastic change occurs, like a market crash, an ideal portfolio is structured to shield some loss. Most importantly, if a rebalance happens post-market crash, investors can put more money to work in weaker areas, boosting rates of return.

Modern Portfolio Theory Criticism

The biggest criticism of MPT relates to the four most dangerous words in the investment world: It’s different this time. In the late 1990s, people felt that technology company stocks made fundamentals “different this time.” In the early 2000s, terrorism made it “different this time.” Before the Great Recession, real estate made it “different this time.” Since 2020, COVID-19 makes it “different this time.”

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Although not predictable, investors historically get burned for acting on these dangerous words. Diversification, low cost and rebalancing aren’t always as exciting, making it difficult to follow MPT when emotions try to overwhelm logic and the belief that “it’s different this time” is strong.

Mark Berger is a certified financial planner and owner of Berger Financial Group, a full-service financial firm located in Plymouth, Minn.

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