What Is Modern Portfolio Theory (MPT)?Modern portfolio theory (MPT) is a fundamental strategy that won the Nobel Prize in Economics back in 1990 and has since become a staple of most wealth management. We’re breaking things down to provide a deeper understanding of how this theory works and how you can use it to your advantage when planning your portfolio.The Basics of MPTThere are three primary components of modern portfolio theory:Pick a fully diversified portfolio—meaning stocks and bonds, US and foreign, small and large companies, etc.Implement your portfolio with very diversified, low-cost investments.Rebalance the portfolio on a regular basis.These three things sound quite straightforward upon first glance. However, sticking with the strategy can sometimes be difficult because an investor is never fully concentrated where things are doing best. While an investor owns top-performing assets, he or she will also own the asset class doing most poorly. This is due to the full portfolio diversification. Let’s take a closer look.Pick a Diversified PortfolioThankfully, picking the “right” mix is an extremely loose imperative, as certain people can prefer higher concentrations in certain types of investments. The key factor that is most difficult to stick with is that this allocation needs to remain constant throughout time, not shifting around to chase the hot sectors of the market.Implement Your PortfolioImplementing a low-cost, diversified portfolio is getting simpler these days, as it can easily be done through very low-cost index funds. There are still some nuances here, but overall, many people are increasingly aware of using this type of investment vehicle to construct their portfolio.Rebalance RegularlyThe final step, rebalancing on a standardized basis, is where much of the benefit occurs. Certain sectors of the investment world are going to go up in value through time, and others will do poorly, at least on a relative basis. This means that your initial diversification between your various asset classes will morph through time unless you keep it rebalanced. Thinking through what this means, you are selling a little bit of what has done the best, and buying a little bit of what has done more poorly. This can seem counterintuitive, but it ends up helping investors sell high and buy low over time.Rebounds do not happen specifically quarterly or annually, although these remain very common choices. You could also rebalance when things hit a certain threshold out of balance, or use nearly any other method if it is defined in advance and consistently implemented.Modern portfolio theory states that if these three rules are followed, an investor should make more money with less risk over long periods. At the end of the day, this is what people generally want—although it remains difficult for people to follow the simple rules over their lifetime.Modern Portfolio Theory at WorkStill confused? Think of it this way. A typical retiree might have a portfolio resembling the following:40% bonds30% large U.S Companies10% small U.S Companies20% foreign companiesEach of these categories has a corresponding market index, but indexes cannot be directly invested in. Investment advisors can help figure out a cost-efficient and diversified way to fill up these category targets and help people implement the strategy.Once everything is set up, not much attention needs to be paid unless a drastic shift occurs. In most cases, you would wait a year before rebalancing. If some drastic change occurs, such as a market crash, the portfolio is structured to ideally shield some of this loss. Most importantly, if a rebalance happens after a market crash, it helps investors put more money to work in the areas that have been weakest, which historically boosts rate of return.Modern Portfolio Theory CriticismThe most significant criticism of MPT relates to the four most dangerous words in the investment world: “It’s different this time.” In the late 1990s, people felt that technology company stocks made fundamentals different this time. In the early 2000s, terrorism made it different this time. Before the Great Recession, real estate made it different this time. And, in recent years, governments and politicians are making it different this time.Although this pattern can’t be predicted, investors historically get burned for acting on these dangerous words. Diversification, low cost, and rebalancing aren’t always as exciting, which makes it difficult to follow MPT.BFG and MPTAt Berger Financial Group, we follow MPT to a large extent, supplementing it with risk management strategies. MPT can be used in any stage of life, despite the varying levels of risk investors might wish to take. The most glaring aspect of portfolios that changes between younger and older people tends to be the amount of aggressive versus conservative investments, such as stock versus bonds.At BFG, we offer a team of highly skilled portfolio managers as well as certified financial planners that are well versed in choosing the right type of portfolio for you. We’ll help you make smart investment decisions at any and all stages of life. Contact us to learn more about how we can help achieve your financial goals.