What are the efficient frontier and modern portfolio theory? And why do we care?
Modern Portfolio Theory
Modern Portfolio Theory is based on the work of Harry Markowitz, a graduate student from the University of Chicago. At the time, there was a strong emphasis on choosing individual equities and the underlying fundamental value of the company. Markowitz suggested that it was important to consider risk as well as return. His calculations demonstrated that by diversifying a portfolio with stocks that are not perfectly correlated, the portfolio risk can be reduced, even though the risk of the individual stocks remained the same.
The Efficient Frontier
The efficient frontier is the model used to build a portfolio that balances risk and reward. You can see an example of the efficient frontier above from an analysis of my portfolio by Personal Capital. The red dot is a portfolio made of 100% stocks and the blue dot is a portfolio entirely made up of bonds. The efficient frontier is the curved line in the center. It shows the most efficient balance between risk and reward, which means the lowest risk for each return and the highest return for each risk. My portfolio is marked by the X and the ring is the recommended portfolio by Personal Capital. As you can see, my portfolio is efficient because it is on the line, not below or to the right of it. However, my portfolio is slightly riskier than Personal Capital's recommended portfolio, which I am ok with because I have a long time horizon and high risk tolerance.
Many people will have a portfolio that lies somewhere to the right and below the efficient frontier line. If you find your portfolio lies here, you have two opportunities to become more efficient. You can move to the left until you run into the line, which indicates the same returns with less risk. You also have the opportunity to have higher returns with no additional risk by moving straight up until you hit the line.
I don't expect you to calculate your portfolio risk and reward or completely understand the calculations behind modern portfolio theory. However, you can still use the theory and efficient frontier analysis to help you build your portfolio. Personal Capital has a free app that includes the efficient frontier as part of the desktop version of the Investment Checkup. They provide recommended allocations that you can use to guide you while determining your allocation.
Criticism of MPT
There is some criticism of Modern Portfolio Theory due to its assumptions. Modern Portfolio Theory assumes that the investor is rational and invests based only on risk and return. It also assumes that estimated risks and returns are known to investors and fixed through time. There are a few other assumptions, but the biggest criticisms surround these assumptions.
As you probably suspect or know from personal experience, investors can be irrational and have additional influences other than risk and return impacting their investment decisions, namely psychological factors. Selling during a crash or buying as the market soars are examples of irrational behavior influenced by psychological factors such as fear, euphoria, or greed. Furthermore, while we can use historical data to estimate risks and returns, future risks and rewards are unknown and not static. World events and economic factors can cause risks and rewards to vary over time.
Current Influences
Despite these criticisms, Modern Portfolio Theory is still a useful tool. You may be utilizing Modern Portfolio Theory already without even realizing it. Most robo-advisors use portfolios that are based on Modern Portfolio Theory. Robo-advisors will ask you questions to determine your risk tolerance and goals and build a diversified portfolio that is along the efficient frontier. The emphasis on diversifying your investments is based on reducing risk by investing in non-correlated assets. The idea that the overall portfolio is more important than the individual stocks is a key part of index investing. The impact of this theory was so influential that they gave Harry Markowitz a Nobel Prize for Economics in 1990. So toast Harry Markowitz the next time you check your portfolio. There's a good chance your portfolio would look a lot different if he hadn't published his theory.
Source: Evansky, Harold, et al. The New Wealth Management: The Financial Advisor's Guide To Managing and Investing Client Assets. John Wiley & Sons, Inc., 2011.
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