At first glance, your account statement might look like it’s written in a foreign language. With terminology like large-cap, small-cap, emerging markets and fixed income, it can feel like a mysterious veil surrounds even simple asset allocations.

No matter how complicated it might seem, however, chances are whoever assisted you with your allocation – whether it’s a financial advisor, an allocation fund, or just someone in the know – used some form of Modern Portfolio Theory (MPT) to arrive at the results.

Modern Portfolio Theory at a Glance

Leaving highly technical aspects of the theory like efficiency frontiers out of the conversation, Modern Portfolio Theory was developed in the 1950s to help investors maximize long-term returns relative to what they deem are acceptable amounts of risk. It relies on a buy-and-hold mentality with consistent rebalancing rather than an approach that seeks returns through market trends and technical analysis.

From a layman’s perspective, MPT uses the most suitable combination of stocks and bonds – as well as specific and types of stocks and bonds – that, collectively, work in unison to provide appropriate levels of growth and risk according to an investor’s goals, time horizon, and personal level of risk tolerance.

Relying on a few simple notions – large-cap stocks display less volatility and long-term growth than small-cap stocks, and fixed income instruments like bonds are more stable than stocks, – portfolios are constructed based on these concepts to arrive at a resulting allocation that is as efficient as possible in its trade-off between growth and risk.

Of course, investors can have different allocations for different goals, usually using varying time horizons as the basis for that difference. In other words, for an investor that is saving for a retirement that is still decades down the road, they can afford to be riskier with their allocation and, therefore, use far more stocks than bonds as well as a greater ratio of small-cap, foreign, and emerging markets stocks to large-cap stocks.

Conversely, the closer that investor gets towards retirement, the more bonds should be used relative to stock as well as large-cap stock relative to small-caps. According to Modern Portfolio Theory, the same methodology can be employed for any investment goal – not just retirement – as long as careful consideration is given to time and risk.

Average Investors Should Have a Basic Understanding of MPT

Although MPT can be explained in far more complicated terms, the discussion of growth, time, and risk is more than enough to have a novice understanding of the concept. This understanding can prove to be extremely valuable when discussing your investments with your financial professional.

While no one expects you to have a world-class knowledge base concerning asset allocation, having a decent handle on the concepts used to develop your allocation in the first place can make your conversations with your advisor far more efficient and enlightening.

 

About Jeremy

3/18/2019