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
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.