Pursuing high returns typically comes with high risk; for some people, that is fine. For others, they prefer to be more conservative while still seeking viable returns. How does one know when they have the potential for the best return for the amount of risk taken?
We’ll look at ways to pursue an adequate amount of return and the amount of risk that one must take.
Modern Portfolio Theory (MPT) is a strategy used to construct a portfolio that factors in risk and return. MPT seeks to provide the most return for the least risk. Dr. Harry Markowitz created MPT in the 1950s.
A portfolio based on MPT strives to maximize return while managing risk. Financial advisers often apply software to help create a portfolio with those trade-offs. But we can still speak about constructing an MPT portfolio conceptually.
In MPT terminology, the efficient frontier is the point where returns have the potential to be maximized for the given level of risk. Remember, MPT is a theoretical framework, so you aren’t likely to ever hit maximized returns with the lowest risk. In other words, that perfect balance is very difficult to achieve in practice. But that doesn’t mean we can’t use MPT as a guide.
As a side note, returns adjusted for risk, which is what MPT is doing, are called risk-adjusted returns.
One of the first steps to balancing risk and return is creating a diversified portfolio.
How exactly do we strive to maximize returns while managing risk? This isn’t done by choosing a single stock or fund. After all, a portfolio is made up of multiple assets or financial instruments.
Let’s say we choose a high-tech company and put it into the portfolio. The portfolio is now high risk and high return potential. Next, we add a treasury bond of equal weight. This reduces returns and manages risk. Then we continue adding stocks, bonds, and funds while trying to hold a balance between risk and return.
As mentioned earlier, a financial advisor will usually use software to create this risk/reward balance. The way this balance is being maintained is through diversification. We’re choosing assets that are uncorrelated in their returns and risk.
Portfolio diversification manages idiosyncratic risk. That means risk specific to each asset in the portfolio. There is another risk called systematic risk, which we can’t really get rid of. It is a background or market risk that is always present. If you want to hold investments, you must hold market risk.
It’s important to know what risk is. According to MPT, risk is volatility. The previous section mentioned that adding treasury bonds helps manage risk. That’s because treasury bonds are usually less risky than a high-tech company.
We can get a measure of risk through price action. The price of a high-tech company can fluctuate quite a bit, while a treasury bond’s price doesn’t move around too much. The high-tech company is considered volatile because its price moves a lot. MPT would say the high-tech company is also risky.
If a portfolio is overweight in volatile high-tech companies, the portfolio's value can fluctuate. Weighting the portfolio to less volatile bonds can reduce the price fluctuations in this theoretical portfolio. With reduced price fluctuations, MPT would consider the portfolio to be less risky.
The trade-off is not to reduce the portfolio's risk so much that the portfolio no longer produces meaningful returns. But that is where an investor must maintain the risk/reward balance. A financial adviser can help you construct a portfolio that follows the MPT framework.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. All investments have an inherent level of risk. The value of your investment will fluctuate with the value of any underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.