Modern Portfolio Theory (MPT)
Is a groundbreaking approach to investment management, developed by American economist Harry Markowitz in his 1952 paper “Portfolio Selection,” which earned him a Nobel Prize. Markowitz’s theory has had a profound impact on how investors manage risk and return, revolutionizing the world of finance.
As Markowitz emphasized, the key to long-term success in investing is diversification—a strategy that can help increase returns without adding unnecessary risk. His work demonstrated that by investing across a broad range of assets, investors can build portfolios that are not only resilient but also capable of achieving optimal returns over the long run.
Why Diversification is Key
Markowitz’s theory introduces the concept of placing investments along a ‘risk continuum,’ where assets range from high risk/high return to low risk/low return. The key to achieving the best results, according to MPT, is finding the right balance of these assets based on an investor’s risk tolerance.
At GFWM, we apply these principles rigorously, going beyond the traditional mix of bonds and equities that many so-called ‘multi-asset portfolios’ rely on. Our portfolios are highly diversified, incorporating a broad spectrum of asset classes to help manage risk more effectively. This diversification ensures that no single market shock can heavily impact portfolio performance, as different asset classes tend to respond differently to market conditions.
>Diversification = > returns < risk
We use advanced analytical tools to assess a portfolio’s risk, including its historical volatility and the correlations between its various asset classes. By incorporating a wide range of assets that move independently from one another, we are able to maximize the ‘diversification benefit’—the reduction of risk that comes from having uncorrelated investments. For instance, during the COVID-19 market correction, commodities soared while many other assets fell, helping to cushion the impact.
Our GFWM Growth Portfolio
Our analysis shows that, without the benefit of diversification, our growth portfolio’s constituent funds risk score would be 117.
However, thanks to a diversification benefit of 31%, the risk score is reduced to just 81, making it less risky than the constituent funds.
This is an especially important aspect of portfolio construction and if implemented can make a significant difference to a portfolio’s behaviour during challenging market conditions.
How does your current portfolio measure up?
A large proportion of our work here at GFWM is spent analysing our clients’ current portfolios to ensure that they are aligned with their risk profile and have demonstrated superior track record of past performance (whilst no guarantee of future performance it is a good way of filtering down to likely candidates to study in greater detail).
What makes MPT so effective? The answer lies in the asymmetric impact of returns: losses hurt more than gains help. MPT helps investors mitigate losses by diversifying across different asset classes, which reduces the overall risk. This approach requires discipline and a long-term focus, as it discourages short-term market chasing in favour of a steady, diversified strategy.
At GFWM, we implement MPT with precision, ensuring that portfolios are built with both growth potential and risk management in mind. Our highly diversified portfolios are structured to navigate even the most volatile market conditions, providing investors with confidence and peace of mind.
It’s worth pointing out here that our Growth portfolio tends to be for those happy to take risk as they have significant understanding of investing, personal wealth and/or a long investment horizon but we have equally good solutions for medium and lower risk investors (our Cautious and Balanced Portfolios).
A real-world illustration of diversification benefit
The charts below show how a client’s current fund rated by FE FundInfo’s risk profiler with a risk score of 93, significantly lower than the 117 score of our growth portfolio’s constituents, fell significantly more during the ‘COVID market correction’, and took significantly longer to recover:
GFWM Growth Portfolio – A Diversified Strategy for Growth
The GFWM Growth Portfolio is designed for investors seeking a higher risk, growth-focused strategy. Comprised of 16 carefully selected funds, this portfolio has consistently outperformed its benchmarks, delivering significant long-term value.
Conclusion
At GFWM, we dedicate a substantial amount of time analysing and constructing portfolios to align with each client’s risk profile, while also looking at track records of past performance. (whilst past performance is no guarantee of future results, it’s a strong indicator for identifying potential opportunities for further study).
By Mark Stephens CFP (Financial Planner)
mark@goddardfry.co.uk