Modern Portfolio Theory
The world’s leading academic economists conducted extensive research, demonstrating that asset class selection (such as small-cap vs. large-cap, value vs. growth and U.S. vs. international)-not stock selection or market timing-is the most important determinant of portfolio performance. Further, the founders of MPT received a Nobel Prize for revealing these four tenets.
Basic Tenants of Modern Portfolio Theory
- Markets process information so rapidly when determining security prices, that it is extremely difficult to gain a competitive edge by taking advantage of market anomalies or inefficiencies.
- Over time, riskier investments provide higher returns as compensation to investors for accepting greater risk.
- Adding high-risk, low correlating asset classes to a portfolio can actually reduce volatility and increase expected rates of return.
- Passive asset class fund portfolios can be designed to deliver over time the highest expected returns for a chosen level of risk.
Opposite of Traditional Stock Picking
Modern Portfolio Theory is the philosophical opposite of traditional stock picking. It is the creation of economists, who try to understand the market as a whole, rather than business analysts, who look for what makes each investment opportunity unique. Investments are described statistically, in terms of their expected long-term return rate and their expected short-term volatility. The volatility is equated with “risk”, measuring how much worse than average an investment’s bad years are likely to be. The goal is to identify your acceptable level of risk tolerance, and then to find a portfolio with the maximum expected return for that level of risk.
Participate Intelligently in the Market
The core message of MPT is that volatility can be planned for, and that diversification and index investing let average people participate intelligently in the market.
Prudent Investor Rule
A vast majority of states have passed legislation with major revisions to the Prudent Investor Rule
A summary of these are:
Modern Portfolio Theory (MPT) is adopted as the standard by which fiduciaries invest.
Fiduciaries can avoid liability by exercising reasonable skill and care in making a delegation to an agent that will be held to the same standards as the fiduciary.
May of 1992 American Law Institute (ALI) Third Restatement of the Prudent Investor Rule recognizes:
Little or negative payoff when fiduciaries and other investors try to apply expertise, investigation and diligence in efforts to “beat the market”, particularly after research and transaction costs.
Little correlation between fund managers’ earlier successes and their ability to produce above-market returns in subsequent periods.