Pin Me

The Modern Portfolio Theory and How Affects Your Savings

written by: wearmanyhats•edited by: Laurie Patsalides•updated: 2/14/2010

Few people out of the financial world have heard of the Modern Portfolio Theory (MPT), and yet there isn’t a good financial adviser that doesn’t adhere to its principles. This theory affects how financial planners will look at your portfolio and help you decide how to invest your money.

  • slide 1 of 2

    Theory Basics

    The theory itself was put down on paper in 1952 by Harry Markowitz. He explained the math behind risk, and many Internet sites cite this math in depth. In the simplest form, his mathematical equations proved that diversification lessened the risk to your long term savings. That is why financial planners say, “Diversify, diversify, diversify.”

  • slide 2 of 2

    Possible Areas in which to Diversify Your Long Term Savings

    The MPT uses stock market offerings to establish the core of its principles. However, diversified investments can occur in different fashions.

    Real Estate: Put several rental properties, bought for a good to fair price, into you portfolio, and over time the units pay themselves off, make use of depreciation, and increase your wealth. Holding only real estate heightens the risk to your portfolio, as when the market bubble burst in 2005. Portfolio values may have plunged then, but not if you had other investments that hedged those losses.

    Precious metals: These guard against economic instability. They are usually bought when times are stable and the price is low. They regain their luster as their prices shoot up. A safety deposit box filled with silver and gold coins will perk up an investor’s portfolio when inflation is raging.

    Collections: These often involve both a passion and a hobby. Some items that hold their worth include art, pristine antiques, rare or unique furniture, famous original maps or documents, original writings from famous people, original movie posters, cartoon cells, and sports memorabilia. These types of items need to be appraised and insured; those costs are figured into the value of keeping the overall portfolio.

    Futures: Financial advisors may wish to entice the accredited investor into investing in the future market as a way to liven up the average portfolio. These investments require more guidance, and it is the one area that investment brokers can still make lots of money on their advice. Futures are risky, which is why the Security and Exchange Commission has tight requirements on who can use these investments. Ironically, the MPT maintains that the riskiest investments help lessen the over all portfolio risk, a tough concept to follow. Investors who buy out of favor investments, then hold them in their portfolio long term, bring the greatest returns with the least risk to their savings. This is never factored into the MPT.

    This theory of risk assessment has become the cornerstone of saving and investment management. The idea of diversification is found in every basic financial magazine and book. It is doubtful that Markowitz’s goal of completely eliminating risk will ever happen, but diversifying can lessen the pain during any kind of downturn.