Modern Portfolio Theory is a mathematical design for creating a portfolio of assets such as stocks, bonds, real estate, cash, commodities and possibly other asset classes whereas the expected return is maximized for a given level of risk. Its key theory is that an asset’s risk and return should not be assessed by itself, but by how it contributes to a portfolio’s overall risk and return.
Economist Harry Markowitz introduced Modern Portfolio Theory in a 1952 essay for which he was awarded a Nobel Prize.
Asset classes have different rates of return and risk characteristics based on historical averages. For instance, large cap stocks as identified by the Standard and Poor’s 500 Index have achieved a five year average return of 13.64% and a risk measure of 10.17 according to Morningstar, while 1-5 Year Treasury Government bonds as measured by Barclays had an average five year return of 3.68%, but a risk measure of 1.34 (standard Deviation) Morningstar.
Consider; in 2008 the S&P 500 as measured was down -37%, while the Barclays 1-5 year treasury was up 29.37. Consider all the different asset classes and each working together in its own separate way within a portfolio and Modern Portfolio Theory starts to make sense.
Modern Portfolio Theory assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less volatile portfolio. Thus, an investor will take on increased risk only if there is the possibility of achieving higher expected returns. Alternatively, an investor who wants higher expected returns must accept more volatility.
The exact trade-off may be the same for all investors, however different investors will consider the trade-off differently based on individuals feelings about volatility.
The idea is that a rational investor will not invest in a certain portfolio if a second portfolio exists with a more favorable risk adjusted return potential. In other words, if an investor is presented with two portfolios with similar risk characteristics but one portfolio prevents evidence of higher returns with less risk, the investor should choose the portfolio with less volatility but equal or higher returns.
This may be accomplished through identifying the proper ETF or mutual fund which fits in a certain asset class, positioning it correctly based on proper percentage in the portfolio of the entire portfolio value along with other asset classes to achieve the goal.