In the world of investing, there is no shortage of strategies, plots and plans to wield in order to achieve your financial goals. Your risk tolerance, amount of capital available to invest and when you’ll be wanting a return on that investment all factor into choosing the best gameplan when it comes to making passive income.
Modern portfolio theory is one of those frameworks. When people say, “you need to diversify your portfolio,” this is sort of what they’re talking about.
Here’s how it works.
What is modern portfolio theory?
Modern portfolio theory, also referred to as MPT, was first envisioned by Harry Markowitz in a paper published to the Journal of Finance back in 1952; 70 years ago doesn’t sound very modern, but here we are. Markowitz looked at an individual asset and saw a direct connection between risk and reward. High risk led to high reward, and low risk led to low reward. He posited that diversification could help minimize risk while increasing the reward. This theory actually earned him a Nobel Prize in Economics in the years to come.
At its most basic, the theory looks at your entire portfolio instead of one single investment. The goal is to find the lowest variance while achieving the highest return with multiple assets instead of just one.
At its most complex – well we’re not here for that. There are some complicated mathematical formulas used to determine expected return, portfolio variance, return volatility and the Efficient Frontier, a hyperbola also known as the Markowitz Bullet, that are best employed by professionals. Just tell them Markowitz sent you!
Modern portfolio theory pros
The draw of MPT is that it helps minimize risk for the risk adverse. This theory is particularly useful for those starting out on their investment journey, epsecally younger Millennials and Gen Zers who are looking to make some passive income over the years.
The main benefit of the theory is that it aims to reduce volatility and risk while still keeping rewards relatively high.
Modern portfolio theory cons
One of the drawbacks of MPT is that it focuses on overall variance instead of the downside risk. MTP looks at variance as a key factor and does not consider why the variance exists. Risk is determined by probability and not assessed by structural causes. MPT tells you the chances something happens, but not exactly why it would happen.
Some experts – Warren Buffet included – push back against diversification. That’s because it can be seen as a form of hedging your bet. If you’re sure of something and believe it to be a good investment, you stand to make more provided you know what you’re doing. However, you really need to know what you’re doing.
Similarly, contrarian investors who push back against trends and investors focused on assets that are under and over valued, typically opt out of MPT.
MPT and addy
So where does addy come into play with regards to MPT? Well, addy invests in institutional grade commercial real estate. These opportunities typically come with a price tag anywhere from $3 million up to $100 million, which means they are inaccessible to the average investor.
addy, however, makes them accessible. Through crowdfunding, in which addy members can invest anywhere from $1 up to $1,500 towards a single property, the average Canadian now has access to real estate investing and property ownership. What’s more, crowdfunding real estate is a relatively safe investment.
Adding an addy property to your portfolio is a terrific way to diversify, especially if you’ve only dealt in equities or bonds. While historically these were the two main asset classes, many professionals consider real estate, futures and even cryptocurrencies as notable asset classes as well. There are plenty of options for diversification!
Even within addy, you can practice some elements of MPT. Real estate investing opportunities fall into one of four categories based on their risk: Core, Core Plus, Value-Add and Opportunistic. One way to adapt MTP into your addy investments is by making sure you own a piece of each type of property.
Invest with addy
addy welcome residents in four of our unlocked provinces in Ontario, B.C., Alberta and Quebec to invest in commercial real estate. Signup is quick and easy: just prove you are of age in your province and then you can fund your wallet and start investing.
2 thoughts on “What is Modern Portfolio Theory?”
Great topic and nice writing, Anthony. Hope to read more theoretical articles from you in the future
Paragraph answering the ? line 3 “high risk led to high risk’..surely led to high reward? Good article, thanks NJC