February 9th, 2013

What is modern portfolio theory? Why should we care, and how can we apply it to our investments?

4 thoughts on “February 9th, 2013”

  1. Aaron Howard says:

    Modern Portfolio theory attempts to manage risk or appeal to risk sensitivity and then with in the constructs of a definition of risk maximize return. Conceptually there are many hurdles to overcome before one is comfortable and able to broaden investment options. Defining risk in terms of a portfolio allows individuals to blend asset types to an acceptable level. In addition the diversification of combining multiple asset types can spread investments across various segments of the market, US stocks, international stocks, bonds, real estate, index funds, etc. Conventional wisdom would suppose that as assets in stock market decline bond markets might increase, hold stead or not decrease to the same degree. This diversification will stabilize returns and market value of the investment. This is useful for investments that need to attain or retain a value for a specific time, but may be less optimal for long term investment. Many low cost investment funds like vanguard and tiaa-cref have pre-built funds that blend assets according risk tolerance or specific target dates.

  2. Mike Finley says:

    Well said, Aaron. Let’s see how the average person can apply this concept. Use no-load index mutual funds to purchase assets like stocks, bonds, and REIT’s (stock in commercial real estate) that are diversified over entire markets in America and Overseas. Each year one type of investment (let’s say U.S. small companies) will outdo others. The next year will be some other asset’s turn (let’s say REIT’s). We don’t know which horse will win the race in any given year (no one else does either and that is a key point for you to remember going forward). This is why we select the group of assets to moderate our risk and increase our investment return over time.

    We don’t buy more of the hot assets (what is currently doing the best) and we don’t sell our dogs (the asset that is currently doing the worst). We simply buy “the market” and allocate our assets appropriately based on our age, our risk tolerance and our time horizon and then leave it alone (rebalance every few years to fit your asset allocation goals).

    Modern portfolio theory provides us the framework to see our investments as one very big pie rather than multiple little pies. Simply cut it up in pieces (different assets) and patiently let time do its thing (compound interest can make you rich). Nice job, Aaron.

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