The Efficient Frontier – Modern Portfolio Theory, Relevant Today?

Many people strive to be efficient in everyday life, to optimise their level of performance, hoping to minimise the waste of resources such as time and energy. This concept of efficiency can also be translated to your investment portfolio.

By constructing a portfolio containing a mix of different assets, each one producing a different level of return, you can hopefully maximise your return. The Efficient Frontier is the basis of Modern Portfolio Theory (MPT), developed by Harry Markowitz in the 1950s. Pivotal in many respects, one of the largest contributions of this theory was its illustration of the power of portfolio diversification.

The mathematics of portfolio construction addresses the question of how much of an asset class needs to be in a portfolio to achieve efficiency. It also highlights to investors how a portfolio’s expected returns vary with the amount of risk taken.

Asset Allocation And Determination Risk

modern portfolioDetermining your attitude to risk prior to investing will dictate the allocation of assets in your portfolio. Identifying a combination of investments offering sector, geographic and asset diversity, including large, small and mid-cap presence is ideal. The aim is to select a basket of investments which have a low correlation to each other, because they will react differently to each other in varying market conditions. When selecting funds, be aware of stock duplication within funds, as it will affect diversification if several funds in a portfolio hold the same underlying stocks, skewing the asset allocation.

Monitoring And Rebalancing

The theory also highlights the importance of monitoring a portfolio and being proactive in taking steps to rebalance it in line with the determined asset allocation when necessary.

Your adviser can help you to take your time to properly consider your attitude to risk, capacity for loss, objectives and suitability. It is essential to have an up-to-date fact find, regular client reviews and open flows of communication about any changes in your circumstances.

Most investment choices are a trade-off between risk and reward, MPT highlights this and, in answer to the initial question, ‘Yes!’, it is still relevant today.

It is important to take professional advice before making any decision relating to your personal finances. Information within this blog is based on our current understanding of taxation and can be subject to change in future. It does not provide individual tailored investment advice and is for guidance only. Some rules may vary in different parts of the UK; please ask for details. We cannot assume legal liability for any errors or omissions it might contain. Levels and bases of, and reliefs from taxation, are those currently applying or proposed and are subject to change; their value depends on the individual circumstances of the investor. The value of investments can go down as well as up and you may not get back the full amount you invested.

The past is not a guide to future performance and past performance may not necessarily be repeated. If you withdraw from an investment in the early years, you may not get back the full amount you invested. Changes in the rates of exchange may have an adverse effect on the value or price of an investment in sterling terms if it is denominated in a foreign currency.