In our article on risk, we talk about how diversification can be used to manage idiosyncratic risk, but is there a way to also reduce systemic risk? That’s where modern portfolio theory comes in.
The quick take is that a given investment affects the risk profile of your entire portfolio. By combining investments with different risk profiles, you can optimize the risk your entire portfolio takes on relative to your expected return.
A simple example is a two investment portfolio: investment in stock and investment in government bonds.
The risk you take on with stock is primarily in when and how profits are generated and distributed. A recession would decrease corporate profits and drive prices lower. Even though the long run expected return of stock is higher because of the risk premium you should expect for investing in stock instead of government bonds, in the short term, stocks entering a recessionary situation are likely to underperform government bonds because of changing expectations on when (farther out in the future) and how much (less) corporate profit will be distributed.
On the flip side, government bonds tend to do better than stocks in recessionary environments because governments tend to lower interest rates on new debt making higher interest rate debt more attractive and because investors tend to flee to the relative safety of bonds in uncertain environments.
Because stocks and government bonds don’t respond in the same way to market changes as each other, they dampen the overall risk of the portfolio, creating a more consistent, lower volatility return profile for the investor. By adding more and different types of assets to the overall portfolio, we can dampen the risk for a given return even further.
The ultimate goal of applying modern portfolio theory is to optimize return for the risk a given investor is willing to take. This is done by creating an efficient frontier of return per unit of risk and finding a portfolio of assets that fits on that frontier.
A portfolio that fits on the efficient portfolio frontier is an optimal portfolio. It will typically combine several asset classes that together produce a higher expected return for the overall risk in the portfolio than investing in only one asset class in particular would produce. In the above example, the portfolio P1 which contains a mix of stocks and bonds lies on the efficient frontier, providing a higher return than an all bond allocation at a lower risk than an all stock allocation. The trade-off of a small amount of return for much lower risk makes this an attractive option.