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Modern Portfolio Theory

Modern Portfolio Theory: The Framework of Passive Investing

When considering investments one naturally wants to give themselves the best chance of reaching their goals. Some have goals of growing their principal as much as possible and are comfortable with high risk. Some simply want to minimize the chance of loss and therefore want low risk. Others have goals that are somewhere in-between. Maximizing the potential return for each level of risk is the basis of Modern Portfolio Theory. Developed in the 1950’s by noted economist Harry Markowitz, it is the time tested and Nobel Prize winning work that says there is an optimal mix of investments for each level of risk. The idea is that by combining investments that do not always behave the same way one can reduce risk and increase the chances for return.

Different Types of Investments – What the Industry Calls Asset Allocation

As we look at Modern Portfolio Theory, it is important to define some terms. If combining different types of investments can reduce risk and increase chances for return, what are these different investments? Below is a graphic that might help. There are 4 main categories of investments – Stocks, Bonds, Real Estate, and Alternatives. The Industry calls these investments “asset classes”. Each asset class is made up of several sub-asset classes. For example, international, large cap, growth stocks are a specific sub-asset class of stocks.

There are dozens of variations of asset classes within these four types of investments. The important consideration here is that not all asset classes will perform in the same way. By combining these different asset classes we see that there is a relationship between risk and reward. This relationship is illustrated in something called the Efficient Frontier.

Efficient Frontier >>
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