In this guide, we will explore the basics of Modern Portfolio Theory. This theory is a great way to analyze how your investments are doing and what you should do next. In the real world, whether you’re looking for a new investment or evaluating your current ones, it’s important for most investors to understand Modern Portfolio Theory so that they can make informed decisions about where to put their money in order to generate the best returns possible!
This theory is a great way to analyze how your investments are doing and what you should do next.
Below we explain the 3 rules of modern portfolio theory in order for investors to maximize returns and reduce risk of their entire portfolio.
1) Pick the right Asset Classes mix
Investors should seek certain asset classes that can generate positive alpha. This can be achieved by selecting assets on the efficient frontier of modern portfolio theory with asset correlations that will diversify the portfolio as much as possible. The asset allocation should be balanced and include asset classes of stocks, bonds, indices from multiple countries, and currencies. The focus should not be put on equally weighted assets but on different asset classes that can track accurately the whole spectrum of the financial markets in order to successfully achieve proper diversification. A well-diversified portfolio is always protected, up to a certain point, towards the systematic risk generated from the markets. Not only the risk-averse investors should seek to minimize the risk involved in their portfolio.
2) Seek low-cost opportunities for your Investment portfolio
The efficient market hypothesis and modern portfolio theory, developed by the economist harry Markowitz, state that a great emphasis should be put on the selection of low-cost assets. Investors should select investment strategies involving small-cap stocks and mutual funds that generally cost less than buying large-cap blue-chip stocks and bonds. This strategy can also assist to downside risk since by selecting a cheaper asset class, your total cost for fees and maintaining your own portfolio is consequently lower.
3) Rebalance your portfolio to avoid a potential systematic risk
In order to achieve an optimal portfolio with high expected returns and lower idiosyncratic risk for a long time period, you should seek to periodically rebalance your portfolio and always try to find promising stock market opportunities. An efficient portfolio is not only the one with great diversification and low systematic risks but also the one that rebalances accordingly in order to adapt to the new market conditions and future investing world.
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