Looking to Invest? Here Are the Best Ways to Use Modern Portfolio Theory

Modern Portfolio Theory

Now that investing robo-advisors like Blooom are all the rage, chance are you’ve hears the phrase Modern Portfolio Theory (MPT) more often than not.

That’s because many robo-advisors and financial advisors make use of MPT when helping you decide how to invest your money.

Today, the principles of MPT are fairly straightforward and revolve around asset allocation through funds, instead of individual stock picking.

But whether you hire a money manager, use a robo-advisor, or do everything on your own, it’s a good idea to have a basic understanding of MPT before investing.

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What is Modern Portfolio Theory?

Back in 1952, Harry Markowitz published a paper in the Journal of Finance called “Portfolio Selection.”

In this paper, Markowitz suggested that investors could create optimized investment portfolios by paying attention to assets and diversification. He later received the Nobel Prize in economics for his efforts.

The main idea in his paper was that an asset’s individual risk and potential return isn’t as important as how it fits into the overall portfolio.

Instead, Markowitz looked at how to achieve optimal portfolios based on an expected return for a given level of risk. The idea was to use different investments to reduce the overall riskiness of a portfolio.

Over time, Markowitz’s ideas built the foundation for the asset allocation models that are mostly used today. Meanwhile, the concept of diversification and using different levels of risk to optimize a portfolio for specific goals also took root.

But it wasn’t until after the introduction of index funds that MPT really began coming into its own.

The first index fund was launched by Vanguard under the direction of John Bogle in 1975. As index funds grew in popularity, so did the idea that they could be used to create an asset allocation in a portfolio.

With index funds used in MPT, you have instant diversity. And, the composition of your portfolio in terms of assets matters more than the investments themselves.

How do advisors use MPT?

Basically, advisors and robo-advisors use Modern Portfolio Theory to decide how to best construct a retirement portfolio.

Today, the general rule is that you should put together your main retirement portfolio using stocks and bonds. And, one of the common rules of thumb is to use your age to determine the composition of your portfolio.

In the past, advisors commonly subtracted your age from 100 to figure out the percentage of stocks you should have in your portfolio. So if you’re 30, your portfolio should be 70 percent stocks (100-30).

But in recent years, many advisors have determined that index funds are sufficiently diverse to provide a lower level of risk. Plus, with longer life expectancies, you need more time to build a bigger portfolio.

In fact, some advisors now suggest that you subtract your age from 120. That means our 30-year-old would now by invested 90 percent in stocks, with the remaining 10 percent in bonds.

As you age, you are supposed to adjust your asset allocation. You sell some of your stocks (hopefully at a profit) and use those profits to boost the bonds in your portfolio.

Then, as you get closer to retirement, more of your money is invested in assets considered “less risky.”

Today, robo-advisors make use of index ETFs to put together low-cost portfolios based on your long-term risk tolerance.

Essentially, MPT is all about helping you try to get the most out of your retirement portfolio.

Using MPT to your advantage

You can use these concepts to your advantage as you invest for retirement.

If you’re younger, you’re considered by Modern Portfolio Theory to have a fairly high-risk tolerance. You can overcome market setbacks because you have more time to make back any money you lose.

Having more of your portfolio in stock index funds or ETFs while you’re younger theoretically allows you to build your nest egg faster. Since stocks offer higher potential returns than bonds, your portfolio grows at a rapid rate. Even when you factor in market events like what happened in late 2008 and early 2009.

As you get closer to retirement, though, a market event is harder to recover from. After all, you don’t want to have to sell stocks for the money to fund your lifestyle when prices are low.

That’s why, as you approach retirement, you transition to owning more bonds. They are considered less risky, you still get a return, and you are somewhat shielded if stocks crash.

Many experts still think it’s a good idea to keep a portion of your portfolio in stocks, even during retirement. That way you still see some growth in your portfolio.

However, the balance shifts significantly toward bonds as your portfolio goal shifts from growth to income during retirement.

Putting together a retirement portfolio

If you aren’t sure how to start, there are a number of robo-advisors like Betterment that can help you assemble a portfolio.

You usually begin by answering questions about your age and when you plan to retire. Also, what level of risk you can handle.

Then, using the principles of MPT, an asset allocation is chosen for you. The robo-advisor also chooses a mix of stock and bond index ETFs for appropriate asset allocation.

You can do all of this yourself, too.  Just open an account with an online discount broker, then add stocks and bond funds to your portfolio. it’s often easier — and less risky — to take advantage of the instant diversification offered by funds.

When someone else manages your money, your portfolio will automatically be rebalanced as you age. And if the market acts in such a way that your asset allocation gets out of whack by more than five percent or so, a rebalancing will take place.

You can also rebalance your portfolio whenever as needed. Usually no more than once or twice a year, though.

And, of course, you are free to experiment with different investments.

For example, I like to use MPT, managed by a robo-advisor, for my long-term retirement portfolio. I use the money I can afford to lose to experiment with things like real estate investment trusts.

Modern Portfolio Theory offers a solid starting point for building your long-term retirement portfolio. It gives you the chance to build your nest egg during your working years, with an eye towards income as you approach retirement.

While it’s not the be-all-and-end-all in investing, it’s definitely a good place to start.

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