Applying Modern Portfolio Theory to Your Investment Reality

While the idea of an efficient portfolio and the efficient frontier graph make great theory, how can they be applied to your own investment situation?

What's important here isn't the details of the efficient frontier graph, nor finding the most efficient portfolio. Rather, the takeaways from Modern Portfolio Theory are:

  1. Risk and return are directly linked. If you want a chance at greater returns, you'll need to take on more risk.
  2. Diversification across securities that do not behave alike reduces a portfolio's overall risk.

These two concepts are so firmly ingrained among investors that you would have probably used them to build your portfolio even if you'd never heard about Modern Portfolio Theory. For example, your asset allocation is the direct result of your time horizon, risk tolerance, and financial goal. To reach that goal in the appropriate amount of time, you must take on a certain level of risk.

Further, you may be increasing your ability to control risk in your portfolio by mixing investments that have a low correlation with one another. For example, the stock and bond markets don't usually move in the same direction. By having a portfolio that includes both stocks and bonds, you're one step closer to a more diversified, and less risky, portfolio.

Next Step: Learn how to use Scottrade Portfolio Review Tool to create and maintain a portfolio that's efficient for you. Use our Quick Start Guide (PDF) to get started today and, when you're ready, choose from one of five target models that were created to help you apply an investment strategy that helps you work toward your goals.

Keep in mind that while diversification may help spread risk it does not assure a profit or protect against loss in a down market.

Investors should consider the investment objectives, charges, expense, and unique risk profile of an Exchange Traded Fund (ETF) or mutual fund carefully before investing. A prospectus contains this and other information and should be read carefully before investing. A mutual fund prospectus is available through or through a Scottrade branch office. An ETF prospectus must be obtained from the issuer.

The analytical tools described in this article are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision.