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MPT and the Efficient Frontier

By Dr. David Edward Marcinko; MBA, CMP™

[Publisher-in-Chief]

Mean Portfolio Variance Optimization [MPVO] has at its core Modern Portfolio Theory (MPT), which seeks to find the “efficient frontier” that defines the minimum risk for any given level of investment portfolio rate-of-return.  

Efficient Frontier 

In order to find the efficient frontier, MPVO will consider the expected returns, standard deviations (i.e., volatility) and correlation coefficient of individual asset classes within a physician or other investor’s portfolio. 

All things being equal, the physician or endowment fund manager would generally choose investments with the highest expected long-term return.  

However, the current funding needs placed upon endowments, or in personal portfolios, may require that they be sensitive to the volatility of asset classes. These restrictions are the stuff of MPVO. 

Risk of Expected Volatility 

Expected portfolio volatility is often defined as “risk” and measured by the standard deviation of investment returns around an expected average return for that same investment.  

In other words, an asset class with an expected return of 10% and standard deviation of 5% would have its returns range from 5% to 15% approximately two-thirds of the time. 

Two MPVO Types 

• In conventional single period MPVO, a doctor will make his portfolio allocation for a single upcoming period [time-certain], and the goal will be to maximize expected arithmetic return subject to a selected level of risk.  
• In multi-period MPVO, a doctor will be concerned with strategies in which the portfolio is rebalanced to a specified allocation at the end of each period.

Such a strategy is sometimes called Constant Proportion (CP), or Constant Ratio Asset Allocation (CRAAL).  The goal is to maximize the true multi-period (geometric mean) return for a given level of fluctuation.  

Assessment 

MPVO is the quantitative assessment which facilitates portfolio asset allocation by considering the trade-off between risk [expected volatility] versus return [arithmetic or geometric]*. 

* Geometric mean is the n-th root of the product of n numbers – unlike an arithmetic mean – it tends to dampen the effect of very high or low values which might bias the mean if a straight average (arithmetic mean) were calculated.

And so, do you consider MPT and MPVO [which type] when constructing your own investment portfolio? Why or why not? 

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Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

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