The key elements of Modern Portfolio Theory are:

In a financial context, “risk” is the likelihood that your investment return will be lower than expected. This includes the possibility that you may lose some or all of your original outlay. MPT defines risk using various measures of “variance” and “volatility”. These are statistical terms for how much an investment has or is likely to deviate from its expected return.

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In the investing world, there is invariably a trade-off between risk and return. It is usually not possible to generate higher investment returns in the market without being willing to accept greater risks.

Likewise, pursuing a lower risk, safer investment will generally be expected to result in lower returns. This is how free markets work – with investors needing to be offered correspondingly higher rates of return to compensate them for the higher (perceived or actual) risks taken.

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Different classes of assets have different risk/return profiles and, therefore, behave differently over time. Shares tend to outperform other asset classes over the long run but can be more volatile. Bonds generally provide more steady returns but more limited capital long term growth. The fast-growing dynamics of emerging markets (such as Brazil and India) can offer opportunities for strong returns but with less predictability than the lower risk, steadier growth opportunities in more developed economies (such as Australia).

Taking on greater risk doesn’t automatically guarantee higher returns. Riskier investments do not always pay more than less risky investments. This is precisely what makes them riskier!

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Portfolio diversification simply means not putting all your investment ‘eggs in one basket’. Every investment carries risks and is subject to potential unforeseen changes. No investment, not even government bonds, is ever completely safe. If your portfolio is narrowly invested (e.g. in a limited number of assets), then an unexpected change in conditions affecting those assets could have a drastic impact on your returns. However, if your investment ‘eggs’ are spread across a wide variety of asset ‘baskets’, each with different characteristics and profiles, then the risk of your portfolio being impacted by inevitable change will be reduced.

This is because the negative performance of some investments will tend to be offset by the positive performance of others. Over the longer term, the entire portfolio will be expected to yield higher and less volatile average returns.

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There’s far more to diversification than simply investing across multiple asset classes. The challenge is how to choose the best combination of assets which offer the maximum expected return. There isn’t just one optimal portfolio – but rather a series of optimal portfolios. In fact, for every level of return, there is one portfolio that offers the lowest risk, and for every level of risk, there is a portfolio that offers the highest return.

These combinations can be represented graphically on a risk/return graph, and the resulting curve is known as the ‘Efficient Frontier’. Portfolios lying on the ‘Efficient Frontier’ represent the best combination of expected return/risk. Your position on the frontier will be determined by the maximum level of risk that you are willing to take on.

The overlay of our Investment Advisory Committee’s experience and judgment is coupled with this analysis to provide additional confidence that we are making prudent investment management decisions over time.

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Finding an optimal portfolio requires a technique known as ‘mean variance optimisation’. This analyses the way in which asset classes perform individually and against other asset classes. Using this information, it is possible to blend different asset classes (especially those which tend to move in opposite directions to one another) to maximize performance while also reducing overall risk.

We use this technique as the foundation for allocating asset classes across our portfolios. The overlay of our Investment Advisory Committee’s experience and judgment is coupled with this analysis to provide additional confidence that we are making prudent investment management decisions over time.

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