Modern Portfolio Theory – How can you make money on the efficient frontier?

What is Modern Portfolio Theory?

At its heart, MPT is all about diversifying your asset allocation. It's about making sure that your investment eggs aren’t all in one basket.

This makes sense. Say your portfolio holds both stocks and another asset that gains in value when the stock market drops (bonds). You wouldn't have to stay up all night over-worrying about what's happening on Wall Street.

MPT is supposed to help decrease return risk by diversifying into many assets. The theory is that asset classes are not correlated to each other. As one asset goes down in value, another can go up in value. When one asset zigs, another asset zags.

Markowitz’s theory encouraged investors to consider each holding in their portfolio as an integral part of the whole. Each investment is not a separate moving cog. MPT holds that investors should weigh an investment’s potential risk and return in terms of how they can affect the overall risk and return of the entire portfolio.

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The best portfolios are on the efficient frontier

With MPT, investors create portfolios to maximize the expected return based on a given level of risk. And, according to the theory, the best way to identify optimal diversification is through something called an efficient frontier.

The efficient frontier is made of portfolios that offer the greatest expected returns for a given level of risk… or vice versa, the lowest risk for a given level of expected returns. Markowitz — and a cadre of economists who would fine-tune MPT over the decades — created a set of complicated mathematical formulas. They define the boundaries of the efficient frontier.

Luckily, we’re not expecting you to be able to fully master and apply these formulas to your portfolio yourself. That’s because there’s an entire group of services online to help you make the most out of MPT in your own investment portfolio.

How you can use MPT in your portfolio

Robo advisors are among the hottest recent trends in the investing world. These services use computer algorithms to create asset allocations in your portfolio. And, for the most part, these algorithms use the principles of Modern Portfolio Theory.

In fact, Investor Junkie’s favorite robo advisor, Wealthfront, published a white paper outlining its use of MPT, calling it “the best framework on which to build a compelling investment management service.”

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Potential drawbacks to MPT

That’s not to say MPT is perfect. Here are some current criticisms of how the theory doesn’t always hold up well in the real world:

• Taxes and transaction costs: Unfortunately, MPT doesn’t take into account some of the costs that come with investing — e.g., the fees and taxes you may have to pay.
• Not all investors have the same information: It’s a nice thought that all investors can access the same information simultaneously. But unfortunately, this just isn’t true. Investors who have access to more — or better — information can make different choices.
• Asset correlations are not constant: One of the biggest criticisms of MPT right now is that it assumes that asset correlations will always remain the same. However, this might not be the case. (Bonds might not always be inversely related to stocks.) In fact, there have been times in history, like the 2008-9 financial crisis, when assets were closely correlated and they all went down in value.
• Volatility is unpredictable: While MPT seems to indicate that you can predict volatility, you can’t. We’ve certainly seen that during the last 10 years. Additionally, MPT assumes that markets accurately price risk, when they actually don’t.
• Investors don’t influence prices: In many versions, MPT assumes that investors don’t hold any sway over the prices of assets. It also assumes that investors are accurate and 100% rational in their ideas of possible risk/return. We know that none of this is true. Investor sentiment can influence prices, and often investors don’t act rationally.

Conclusion

MPT is certainly not 100% perfect. But it can play a significant role in how your portfolio is built — especially if you use a robo advisor. And its principles can be just as beneficial for your investments as some say that acupuncture or a day at the spa can be for your body.