Many of today’s most respected institutional investors pay close attention to a long-standing theoretical construct referred to as ‘Modern Portfolio Theory’ and for good reason. Modern Portfolio (MPT) was developed in the early 1950s by finance professor Harry Markowitz, who later went on to win a Nobel Prize. Introduced as a ground breaking thesis at the time, MPT has since become a core concept preached in academic finance programmes around the world. Although the original theorem is dated, his basic approach toward optimising an investment portfolio contains important tools valid even in today’s environment of almost unlimited investment choices.

The goal of MPT is to identify the best possible investment programme for each acceptable level of risk. Starting with a defined universe of available asset classes, a much larger number of possible portfolios can potentially be constructed by weighting each asset differently. Furthermore, among the hundreds of possible asset class combinations, just a few so-called ‘optimal portfolios’ become apparent. The line of optimal portfolios expected to provide the best possible return for each level of quantifiable risk is then delineated and referred to as the ‘Efficient Frontier’.

Importantly, MPT relies on the premise that the price movements of individual asset classes are not completely correlated with each other over time. For example, stock prices as measured by a broad index such as the S&P 500, tend to move in a different direction than bond prices over most time intervals. The consistent lack of correlation between asset classes allows for building ideal or ‘efficient’ portfolios. The ultimate goal of optimising a portfolio is therefore creating an asset allocation which maximises a portfolio’s expected return for an acceptable level of portfolio risk, also defined as volatility, along the Efficient Frontier.

Asset classes considered in most models include large cap equities, small and mid-cap stocks, US bonds, international fixed income, high yield bonds, real estate investment trusts (REIT’s), commodities and money market instruments. Software programmes are often used to determine the correlation of these assets over a reasonably long term time frame. These correlations are measured by a number falling somewhere between +1.0 and -1.0.

A correlation of +1.0 means the two assets are perfectly correlated; or, in other words, when one asset goes up, the other asset increases by the same amount. On the other hand, a correlation coefficient of -1.0 means that the asset classes are completely negatively correlated. In this case, when one asset goes up by two percent the other asset can be expected to go down by two percent.

Some results are intuitive. For example, one study shows that the correlation coefficient between large cap US stocks and small cap US stocks is +0.83 and the correlation coefficient between large cap US stocks and large cap international stocks is +0.86. This information suggests that a client having a portfolio invested in entirely just these three asset classes of equities is not very well diversified at all. When markets tumble, as they did in 2008, for example, all three of these categories could be expected to decline together, although most likely they will fall by modestly differing degrees.

In other cases, the correlations are more surprising. For example, high yield bonds historically are much more highly correlated with stock prices than with bond prices. The historical correlation between large cap stocks and high yield bonds is 0.62, versus only 0.15 between investment grade bonds and high yield bonds.

On the other hand, investment grade bonds, tend to be relatively uncorrelated with both high yield fixed income and all three of the equity classes. Therefore, a portfolio with some weighting in investment grade fixed income is generally a more defensive portfolio which is more likely to show up in those portfolios positioned along the Efficient Frontier.

Finding an optimal portfolio also entails a detailed analysis of a client’s risk profile and investment objectives. When identifying an optimal portfolio, the investment manager should start with the client’s risk tolerance and then select the best portfolio for that acceptable amount of risk.

Alternatively, the manager may start with the desired level of return (including both income and growth) and then choose the portfolio which shows the lowest level of risk for that expected return. An inefficient portfolio is one which incurs more risk for the same amount of expected return available from another strategy.

In terms of assessing client risk levels, several key variables are usually at play. The first consideration is liquidity. What percentage of the client’s assets may need to be converted to cash quickly without the chance of losing market value? Other factors include the client’s time horizon, acceptable degree of month-to-month volatility, income requirements and any specific client preferences.

Once the client’s risk level is identified and an optimal portfolio determined, the next step is implementation. The initial asset allocation specifies targets for each asset class, but tactical decisions should be constantly reviewed. For example, if one asset class appears to be overpriced, at least in the short term, profits are taken and redeployed in other assets.

Keeping a portfolio on target is a healthy practice. For example, if a portfolio is initially targeted at 60 percent stocks and 40 percent bonds, the portfolio weightings will often become off target purely as a result of market movement. For example, if the stock market surges 30 percent in a year such as 2013, using the above allocation the equity weighting would grow to comprise over 65 percent of the portfolio. In this case, staying with the target discipline would dictate selling down the equity position at a profit to keep the portfolio in line with its strategic asset allocation.

Although Modern Portfolio Theory is anything but modern, both institutional and retail investors can benefit by understanding its most basic tenets. Clearly, all investments, individually or as a part of a larger asset class group, offer both risk and potential return.

Having a well defined plan is the key to investment success. It also pays to make sure you and your financial advisor have a basic understanding of how assets correlate with each other and an intelligent framework for establishing predetermined benchmarks and objectives.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions.

LOM is licensed to conduct investment business by the Bermuda Monetary Authority.