Modern Portfolio Theory and international practices of its use in building an investment portfolio.

MPT (Modern Portfolio Theory) is based on the work of Harry Markowitz and his followers who demonstrated that when different asset classes with low correlation (for example, stocks, bonds, gold, real estate) are in the same portfolio with a positive actual return, the overall portfolio risk can be lower than that of its individual components and the potential total return is higher. This synergistic effect occurs because as one asset class experiences correction, for example, stocks, another asset class, for example, bonds, increases in value. Thus, the assets compensate for drawdowns in relation to each other and reduce the overall systematic risk (the market volatility risk).

How investors can use it: Asset Allocation Concept. Imagine this situation: your portfolio contains government bonds and corporate bonds of several blue-chip companies in a certain proportion. You are comfortable with the portfolio’s risk but not too happy with its yield. If you decide to increase your yield, the most obvious option is to add tier 2 or tier 3 bonds. This will indeed increase the potential return but it will also increase the overall risk of your portfolio. The solution is to add stocks to your portfolio. If you correctly calculate the proportions, you will maintain the same level of risk and your potential income will increase.

Regular rebalancing of the investment portfolio is a good tool to help control risk as well as potentially increase its profitability. Portfolio managers initially determine the proportion for each asset class so that the overall metrics meet the client’s risk/reward requirements. Over time the proportions within the portfolio will change due to different dynamics of asset growth and market volatility.

When rebalancing, the portfolio should be brought back to its original allocation proportions. In reality, the assets that have increased in value are sold and those that have gone down in price are purchased, and this way you ultimately realize additional profitability.

We can see how effective this approach is by comparing the dynamics of the MICEX index and a portfolio with three asset classes in equal proportions: Russian stocks, Russian bonds, and gold. Over the past 20 years, the MICEX market had an average return/risk rate of 15.6% to 41% while the corresponding numbers for the portfolio (provided it was rebalanced annually) are 18.6% to 22.5%.

As you can see from this example, the portfolio has more return with less risk. By mixing asset classes that have a low correlation with each other (asset classes that do not have the same dynamics) we can control the risk in the client’s investment account and in the case of increased volatility, make additional profit.

Another way to further reduce portfolio risk is to build it partially or fully with exchange-traded funds (ETFs). The assets of such a fund can be allocated among hundreds, and sometimes thousands of instruments. This approach provides optimal diversification and minimizes non-systematic risk.

In conclusion, it should be said that the Asset Allocation Concept provides a wide range of tools for building the optimal portfolio that takes into account all possible life situations and financial goals of the client.