Modern Portfolio Theory

Introduced in 1952 by Nobel Prize-winning economist Harry Markowitz, this mathematical framework contends that by allocating portions of one’s investment portfolio across asset classes that tend to perform differently under the same economic conditions is a way to minimize potential losses while still capitalizing on upside potential. It is rooted in the idea of diversification.

Our understanding of Modern Portfolio Theory is usually filtered through the lens of “risky” versus “safe” investments. The simplified version of the theory’s application manifests in the form of a stocks and bonds investment strategy.

Bond investments tend to do well when the economy is struggling. They are often considered to be “safe” investments, where returns are largely predictable if relatively modest. Stocks might take a substantial hit under those circumstances, so the perception of safety can bolster bond investment performance as investors move money in more conservative positions. On the other hand, when the economy is strong and companies are growing, stock investments can generate substantial returns that the bond market can’t capture. In those situations, money tends to flow out of bonds and into stocks.

By having investments in both stocks and bonds, investors are able to capture upside movement in differing economic climates, which in theory limits total losses on balance. The extent to which a portfolio’s diversification under Modern Portfolio theory skews toward or away from “risky” assets is largely dependent on an individual’s risk tolerance, available risk capital, and financial goals.

It is important to note that past performance is not necessarily indicative of future results, and there is no such thing as a “risk free” investment or strategy. Exceptional economic environments may cause asset classes that are typically not correlated to become highly correlated all at once. The 2008 crash, for instance, saw nearly all asset classes drop in tandem.