(post) Modern Portfolio Theory – Part 2

What’s the ideal investment portfolio?

Most people think of investments as a way to earn money by having their money work for them, and that’s as good an approach as any. The problem is, any investment entails risk, because we don’t know what the future holds. 50 years ago Harry Markowitz won the Nobel Prize for noting if we graph out a portfolio’s long-term risk and return, it normally has an upward slope, in which more return requires more risk.

His colleague Bill Sharp extended this work and created the Sharp Ratio, a simple measure for comparing portfolios on a risk-adjusted basis. But they had to define risk and return mathematically. Return is easy: how much you make divided by how much you start with. But risk is more challenging. They used the notion of variability of returns, or standard deviation. Thus was born Modern Portfolio Theory: diversify your assets to reduce your risk, and there is an ideal combination that maximizes return.

But people don’t invest in a vacuum. They have goals, whether it’s saving for college or planning for retirement or buying a home. These objectives imply a certain required return. But investors don’t have the same ends, and their resources apart from their investments vary. Investments are part of total financial picture: other assets, debt, income, and cash-flow. These are different for every investor. So while it may not be “efficient,” the optimal portfolio will be different for every investor.

Modern Portfolio Theory (MPT) posits that there is one ideal portfolio. Post-MPT challenges this: every perspective is unique. The key is to meet your goals in a way that fits you.

Douglas R. Tengdin, CFA
Chief Investment Officer
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