In designing an investment portfolio, how do you decide which investments to use and in what combinations? For more than three decades, major institutions have used a money management concept known as Modern Portfolio Theory (MPT). The concept was developed at the University of Chicago by Harry Markowitz and Merton Miller and later expanded by Stanford professor William Sharpe. Markowitz, Miller, and Sharpe won the Nobel Prize for Economics for their contribution to investment methodology.
MPT is mathematical in nature and frankly, it can appear daunting. But remember that math is nothing more than an expression of logic. So, when you examine the process of developing a strategic portfolio using MPT, you can readily see the common-sense approach the theory takes – an approach that is counterintuitive to conventional and over-commercialized investment thinking.
According to MPT, for any given level of risk, there is an optimum combination of investments that will give you the highest rate of return. The investment combinations exhibiting this optimal risk/reward tradeoff form the “efficient frontier.” The efficient frontier is determined by calculating the expected rate of return, standard deviation and correlation coefficient for each asset class and using this information to identify the investment combination at the highest expected return for each incremental level of risk.
By plotting each investment combination, or portfolio, representing a given level of risk and expected return, one can describe mathematically a series of points or “efficient portfolios.” Together, the points form the “efficient frontier line.” It’s important to note that, while a portfolio may be efficient, it is not necessarily prudent.
Most investor portfolios fall significantly below the efficient frontier line. Portfolios such as the S&P 500, which is often used as a proxy for the stock market, fall below the line when several asset classes are compared. Investors can achieve the same rates of return with an asset class portfolio with much less risk, or higher rates of return for the same level of risk.
The chart below illustrates the efficient frontier relative to the “market.” Rational and prudent investors will restrict their choice of portfolios to those that appear on the efficient frontier line and to the specific portfolios that represent their own risk tolerance level. You want to ensure that, for whatever risk level you choose, you have the highest possible return on the efficient frontier so you can maximize the probability of reaching your goals.