Talking Money: Modern Portfolio Theory
Joel Dresang: Kyle, we talk about Modern Portfolio Theory. It’s the foundation for building balanced investment portfolios. And I know that it can get really technical, and there’s a lot of academic research that it’s based on. How do you explain it simply to investors?
Kyle Tetting: At its core, Modern Portfolio Theory is really about maximizing returns at a given level of risk.
Joel: So what does that mean to investors?
Kyle: Well, you know, I think most investors are not just concerned about returns. They’re also concerned about what kind of risk their portfolio is taking. They want to know that what they’re getting as far as returns is really compensating the level of risk that they’re trying to take.
Modern Portfolio Theory gives us the ability for investors to really find a level of risk that they’re comfortable with and then maximize returns around that level of risk.
So, for investors, it can be a great thing because they don’t have to take more risk than they’re comfortable with. But they can still participate as much as possible in the returns of the broader market.
Joel: So a little background: Harry Markowitz, a mathematician at the University of Chicago back in the 1950s, figures out ways to diversify investments – putting eggs in more than one basket – and ways of statistically showing that you can balance returns and risks. But then it’s like 40 years later that he gets the Nobel Prize. What happened that it took so long?
Kyle: Well, Markowitz really laid the foundation for the Efficient Frontier suggesting that, yes, you can reduce your risk by adding some non-correlated assets, introducing bonds to an all-stock portfolio.
He did some work on returns as well, but really laid the foundation for a Brinson, Beebower and Hood study in 1986, which essentially sought to attribute performance.
So what they found was that over 90% of return is attributable to the asset allocation. The rest of it: investment selection, market timing, small pieces of the puzzle. But really, Brinson, Beebower and Hood found that more than 90% attributable to that asset allocation.
And it was Markowitz again who really laid the foundation for, being able to minimize risk by picking the right asset allocation.
Joel: It covers your bases. It protects the money that you want to protect and provides for money to grow.
Kyle: That’s absolutely right. And what we really focus on around here is when is that unit of risk no longer worth it?
And that’s a little bit different for every investor. Every investor’s goal is a little bit different. The risk they’re willing to accept, a little bit different.
But ultimately, we have found that there is a sweet spot where taking on that next unit of risk just doesn’t make sense from a return standpoint anymore.
Kyle Tetting is director of research at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted April 3, 2014)