It’s true: Modern Portfolio Theory was introduced 70 years ago and has been actively used in investment management ever since. But in a rapidly changing financial landscape, will MPT continue to have a place? Market historians and investors alike have observed how much financial markets have changed over a relatively short period of time. Quant analysis, constant rumors of new securities products, and the thousands of proprietary algorithms deployed on servers across the globe which effortlessly place millions of trades daily while many of us sleep have all become components of our modern financial market.
We also hear a lot about how the proliferation of electronic trades, which can also help to isolate arbitrage opportunities, are going to replace wealth managers. Indeed, some trading desks do become redundant and shrink or are eliminated entirely. However, with every opportunity lost there seems to be a continuous flow of innovation in the financial marketplace. With so many online trading services available that allow investors to self-manage their portfolios, is Modern Portfolio Theory still relevant in wealth management?
Why should I care about Modern Portfolio Theory when I can just manage all my investments online myself?
Human tendency inclines us to think that newer methods are better, especially with the predominant influence of high-tech in the USA. This can often be true; however, the frequency of success with these new methods will ultimately depend on the kind of investor who’s using them and how investment management and trading services are utilized concurrently. It seems like the term “day-trader” has lost notoriety, but lots of people still “day trade.” Working professionals simply do not have the time to successfully day trade long-term. Balancing levels of risk and reward becomes difficult when assets are being shifted around too frequently.
Wealth advisors use modern portfolio theory (MPT) to manage the delicate balance of riskier securities and those asset classes which produce lower income but also preserve wealth. Trained advisors can help you achieve an optimal level of overall risk and reward for your portfolio composite. A composite return is the highest level of performance measurement for all your assets combined—all stocks, mutual funds, ETFs, fixed income, bonds, and hedge funds together.
What are Efficient Frontiers?
Each asset class is assigned what is termed an “Efficient Frontier.” Reaching the Efficient Frontier means you are gaining the highest return on your investment at a given level of risk. The standard deviation of each asset class’s return is used as a measurement of the Efficient Frontier. An acceptable range of standard deviation gets assigned to each asset class. When the standard deviation of a portfolio exceeds an acceptable range for its asset class, an investment advisor goes to work to find out why.
An unusually low return for a fund could be an indicator of a growing problem. A high return is an obvious pleasant surprise, but a wealth manager will analyze what effect that return is having on the rest of its asset class. After one fund outperforms its expected returns over an extended period, then you can elect to liquidate some of those assets and invest the proceeds into another asset class to “rebalance” the portfolio composite. For example, if the stock market suddenly shifts into “bearish” territory or an industry is particularly “bullish,” a new tactical target might make sense to correct an efficient frontier.
Benchmarking and Diversification
All securities should have a primary benchmark assigned to accurately measure its performance as compared to other funds managed with similar investment strategies. Further, wealth managers assign a primary benchmark to each security, asset class, and sub-asset class. Alternatives such as hedge funds sometimes need a secondary benchmark assignment to show market activity for the underlying assets. The more sub-asset classes invested in, the more diversified your entire portfolio of assets will be.
Phrases like the efficient frontier, standard deviation returns, and secondary benchmarks probably raise more questions than they answer. Fortunately, you don’t need to know how to structure your investments for MPT on your own. The wealth advisory team at SD Mayer has decades of experience helping families and individuals make successful investment plans.
Partnering for success with your portfolio
SD Mayer isn’t tied to a big bank, so we aren’t obligated to sell anyone’s brand of securities. We are here to ensure that you are never in the dark when you have questions that need to be answered. For you, that means our approach to wealth advisement is holistic and transparent throughout our relationship with your family, even years from now.