If you do not know what Modern Portfolio Theory (MPT) is, now may be the time to find out. Developed by the late Nobel Prize laureate Harry Markowitz, MPT has taken over the investing world and has fundamentally changed how investors approach the construction and management of portfolios. Simply put, MPT is a strategy that aims to construct more efficient portfolios by combining different assets to achieve a more resilient and potentially rewarding portfolio. How can investors begin applying such a theory to their investment plan? U.S. News & World Report turned to Dan Tolomay, chief investment officer of Trust Company of the South, to find out.
The first step towards adopting MPT principles to portfolios is diversification. However, it is not enough to merely invest in a variety of assets. Rather, in order to achieve proper diversification that can potentially reduce risk without sacrificing returns, investors must select assets that are not highly correlated. “By combining assets with varying risk and return characteristics that do not move in sync, portfolios can generate higher returns for lower volatility,” explains Tolomay. “In other words, the whole is greater than the sum of its parts.”
In this respect, the level of correlation between different assets is crucial. Although correlations can change over time, sometimes consistent long-term trends can emerge. For instance, bonds and stocks generally have a low correlation, while commodities and bonds tend to exhibit a negative correlation. A more specific example is highly-volatile gold, which has historically shown a low correlation to both stocks and bonds. By incorporating a small portion of gold into portfolios, investors create an opportunity to decrease overall volatility and losses during downturns, without adversely affecting long-term returns.
“Diversifying within asset classes can also capture diversification benefits,” Tolomay tells the publication. “For stocks, consider international companies, multiple market caps, and styles such as growth versus value. While for bonds, geographic diversification is key, as is variation in credit quality and maturities.”
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