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Modern Portfolio Theory

Investors fall into two basic categories: active investors and passive investors. Active investors believe in trying to time the market and picking winning stocks. Passive investors believe in capturing the returns markets provide and doing so in a low-cost, tax-efficient manner.

While few (if any) would argue that markets are perfectly efficient, we believe that markets are largely efficient. We believe there is no feasible way to determine which stocks will rise, nor is there a way to identify managers who can. Instead, we believe that the most prudent way to build client portfolios is to tailor the portfolio to match the investor’s ability, willingness and need to take risk. We also believe in constructing these portfolios in the most low-cost and tax-efficient manner possible.

Our approach to investing is based on academic research. We subscribe to the Nobel Prize-winning Modern Portfolio Theory (MPT), which has four basic concepts:

  1. Markets process information so rapidly when determining security prices that it is extremely difficult to gain a competitive edge by exploiting market anomalies.
  2. Over time, riskier assets provide higher expected returns as compensation to investors for accepting greater risk.
  3. Adding high-risk, low-correlation asset classes to a portfolio can actually reduce volatility and increase expected rates of return.
  4. Passive asset class fund portfolios can be designed with the expectation of delivering over time the highest expected returns for a chosen level of risk.

MPT shows that us diversification within and across asset classes is of utmost importance. Investing can be risky enough. Taking additional risk by placing assets in just a few investments is not a prudent way to achieve financial goals (especially since undiversified risk has not historically resulted in superior expected returns). We build portfolios that diversify within and across asset classes to lower the risk of portfolios while maintaining similar (or even the same) expected returns.

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