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Portfolio Management and Modern Portfolio Theory

Simply put, portfolio management is the process of putting together and maintaining a mix of investments.  It involves decisions about investment objectives, asset allocation, and risk management, all in an attempt to maximize returns within the parameters set by the investor.  The portfolio management process can be as simple or as complex as the investor's needs require.

Most professional registered investment advisors today will use either Modern Portfolio Theory (MPT) or one of its variants to construct a complete portfolio for clients.  MPT hypothesizes that investors should maximize their return to their risk tolerance level; the more risk that an investor is willing to accept, the more reward they should expect.

Key Principles of MPT

MPT involves three key decisions, repeated as required by the investor's needs:

Asset allocation

Different asset classes perform better under certain conditions than others, and these conditions will vary over time.  Asset class can refer to size of the company (large cap, small cap), regional focus (domestic, international), types of investment vehicles (stocks, bonds, commodities), or any other type of category the portfolio manager wants to apply.  By dividing investments into different asset classes, the investor can better ensure that they are able to diversify their portfolio adequately, thus preparing their portfolio for many different economic conditions.

Diversification

Within each asset class, there will always be some winners and some losers.  Diversification within each class decreases the risk of inadvertently picking an underperforming stock in an otherwise overperforming asset class by investing in a broad array of options.  A fully diversified portfolio will be diversified both within and across asset classes.

Rebalancing

Over time, an untouched portfolio will become unbalanced, as top performers make up proportionally more and more of the portfolio as a whole.  This can inadvertently expose the investor to unintended risk.  By rebalancing the portfolio back to a risk-appropriate level of diversification and asset allocation, the investor can protect their gains from sudden market shifts away from the conditions which had led to those gains.  Rebalancing should be conducted at least yearly on passively managed portfolios, and more frequently on actively managed ones.

The Efficient Frontier

Every possible portfolio combination can theoretically be plotted onto a graph which compares risk, measured in terms of volatility, and expected return.  If an investor takes on greater risk without a commensurate potential return, they are making their portfolio less efficient.  The ideal portfolio at any risk level can be found along the efficient frontier, which represents the most efficient mix of the two.

Portfolios which lie beneath the curve are less efficient, and can be optimized.

Limitations of MPT

MPT is not without its critics.  There are three main reasons why MPT may fall short:

  1. MPT assumes that all investors are rational and risk-averse, when in fact most investors have difficulty in identifying their own risk tolerance levels, a challenge which impedes their ability to respond rationally to market trends.
  2. Not all investors are equally informed about relevant information.  Professional portfolio managers will by necessity need to keep a closer eye on markets and conduct a more in-depth analysis of individual assets than the average investor is capable of.
  3. Individual investors have difficulty gauging what kinds of returns are reasonable for a given risk level.  MPT is more than just a mathematical model, but requires a deep level of qualitative knowledge as well.

Be sure to ask your advisor what theory of portfolio management they are using to construct your portfolio, as this can tell you much about their investment philosophy and trading strategies.  Still have questions?  Let us know.