What is modern portfolio theory and how are Plenty portfolios constructed?

tldr; we’ll walk through the basics to help you understand how Plenty portfolios are created to balance out risk and return, in a diversified portfolio. We’ll start with some basics on risk and return, before helping you understand how we construct your portfolio.

• What is return?

• What is risk?

• What is modern portfolio theory?

• How does this work in my portfolio?

What is return?

A return is the amount of money you make back on an investment. Two common examples of returns:

• If you invest in a stock at $10 and sell it at $15, you’ve earned a $5 return.

• If you invest in a stock at $20 and it pays a $2 dividend and it stays at $20, you’ve earned a $2 return.

Returns can be expressed in $’s or a %. If it’s a percentage, the return is related to the amount you invested:

• If you invest in a stock at $10 and sell it at $15, you’ve earned a $5 return. That’s a $5 return on a $10 investment, and a 50% return.

• If you invest in a stock at $20 and it pays a $2 dividend and it stays at $20, you’ve earned a $2 return. That’s a $2 return on a $20 investment, and a 20% return.

What is risk?

Risk is a financial concept created to help measure and compare the reality that no investment is guaranteed, and there’s a chance you could lose money. There are many types of risks that could impact an investment, including:

• Operational risk: take Tesla as an example - let’s say an employee accidentally damages a critical piece of machinery that produces a part used in all cars, and production has to slow down. That could lower sales and revenue which might cause the stock price to decrease.

• Regulatory risk: using TikTok and Bytedance as an example, the US government has required that Bytedance sell off TikTok or be shut down. Every company is exposed to some degree of regulatory risk if the government takes action against the company or their products / services.

• Interest risk: let’s say you’re a mortgage company who issued a number of 30 year loans at a 2.5% interest rate. When the federal funds rate increases to 5%, the value of the loans you’ve issued decrease because new loans have a higher interest payment. That lowers the value of your company since the loans you hold are now worth less.

There are over 10 types of risks and all these roughly summarized in a commonly thrown around term called ‘risk’.

What is modern portfolio theory?

At scale in the financial markets, higher returns usually require taking on more risk. Said differently: it’s hard to earn more without making a bigger bet. If I can earn the same amount of money with a lower chance of my investments going down, then I’d take the safe path. When every investor acts from a similar approach, that creates a financial-system level pressure where return and risk are balanced.

That’s the core of Modern Portfolio theory. It’s a Nobel-prize winning portfolio composition strategy that captures the reality that investors expect to earn higher returns if they take on more risk. In order to do that, portfolios are created with a number of asset classes to find the ideal amounts of each asset class where the returns are highest but the risks are lowest. Using more asset classes creates what investors often call diversification.

How does this work in my portfolio?

Using the formulas laid out in the Modern Portfolio theory, there are 10 different portfolios you can choose from on Plenty. Each different portfolio represents a different level of risk. At each level, there is a different % of your investments automatically made in stocks vs. bonds are changed to find the point where there is the highest return for that level of risk.

When you create a Plenty investment goal, we look at your responses about investing comfort, response to risk, and your personal goal characteristics to create a portfolio recommendation. Once you confirm a portfolio, we do all the work to invest according to that target mix, then continually monitor it to see if there are any additional trades that need to happen to keep it balanced to the portfolio you wanted.

Modern Portfolio theory is the most common strategy that financial planners and portfolio managers base their investment strategy on. And they often make things sound more complicated than they are, to justify a 1% fee.

While a 1% fee may not sound too bad, Forbes latest article reports how a 1% fee can wreck your retirement.

• If you invest $1,000 per month over 40 years, your investment could grow to $5.8M

• An annual 1% would take your portfolio down to $4.3M

• Total amount paid to your financial planner: $1.5M

Plenty only charges 0.20% annually because we want families to keep more for themselves. If you’re interested in trying it out for yourself, you can easily get started with a “Start Investing” goal in Plenty today.

Sources

The Investopedia Team, “Modern Portfolio Theory: What MPT Is and How Investors Use It.” Investopedia. August 29, 2023. https://www.investopedia.com/terms/m/modernportfoliotheory.asp

CFI Team, “Modern Portfolio Theory (MPT).” Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/modern-portfolio-theory-mpt/#:~:text=The Modern Portfolio Theory (MPT) refers to an investment theory,prefer the less risky portfolio.

“What is Risk?” https://www.investor.gov/introduction-investing/investing-basics/what-risk

Maverick, J.B., “Financial Risk: The Major Kinds That Companies Face.” Investopedia. December 30, 2023. https://www.investopedia.com/ask/answers/062415/what-are-major-categories-financial-risk-company.asp

About Plenty

Plenty is a wealth management platform designed specifically for couples. We go beyond budgeting, making it simple to invest, save, and grow toward your future goals by unlocking access to the financial strategies of the wealthy. Ready to get started? Sign up for free today.

Enjoying the blog? Sign up for our newsletter for the latest news and expert advice about money, relationships, and everything in between. 

——

The information provided herein is for general informational purposes only and should not be considered individualized recommendations or personalized investment advice. The type of strategies mentioned may not be suitable for everyone. Each investor should evaluate an investment strategy based on their unique circumstances before making any investment decisions.

Investing involves risk, including risk of loss. Past performance may not be indicative of future results. Asset allocation, diversification, and rebalancing do not ensure a profit or protect against loss in declining markets. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. We recommend that you consult a tax professional before taking action.

Plenty does not provide legal or tax advice. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic, and geo-political conditions