Q

What is modern portfolio theory?

A

It's the award-winning idea that it's better to have a diversified investment portfolio than to hand-pick stocks.

In the 1950s, a guy named Harry Markowitz won a Nobel Prize for figuring out how to manage your retirement account. That’s an oversimplification, of course, but what you need to know is that a great deal of what governs the advice almost all financial advisors give comes from the work of this man.

Before modern portfolio theory was developed, the operating principle of investing was to look at individual stocks and pick “winners” — equities that would produce decent returns without too much risk. The problem was that individual stocks are risky by nature. This new theory said that what investors should seek instead is diversification. That way, you bet on bigger slices of the economy and take advantage of “winners” you might not have thought of, while protecting yourself against unforeseen disasters. By finding a combination of stocks that won’t have wild swings in value but will provide decent returns, followers of modern portfolio theory will minimize risk and maximize reward

But be careful: not understanding the reasoning behind what you’re doing is the biggest risk involved with trying to implement modern portfolio theory. People who wake up one day and say, “I’m going to create the perfectly optimized portfolio!” without knowing what they’re doing or understanding the math behind it will likely fail. Also, because the data used to calculate the perfect portfolio is based on past performance, there is no guarantee that it will yield the same results in the future.

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