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What Do Physicians Need to Know about Modern Portfolio Theory?

By: Varun Verma, MD

Published: Feb 2, 2024

📂 Physician Perspectives

Written for:

✅ Residents and Fellows

✅ Early Career Physicians

✅ Mid Career Physicians

✅ Established Professionals

Many physicians may have noticed others on social media forums talk about ‘VTSAX and chill’ and have no idea what that means. In today’s blog we will discuss modern portfolio theory and why some people are obsessed with VTI or VTSAX as core holdings in their portfolios because they offer a simple and cost-effective way to gain exposure to the U.S. stock market.

Modern Portfolio Theory (MPT) is a framework for optimizing investment portfolios based on the principles of diversification and risk management. It was developed by economist Harry Markowitz in the 1950s and has since become a fundamental concept in finance. Here's a brief overview of MPT and why some investors are drawn to ETFs like VTI (Vanguard Total Stock Market ETF) or mutual funds like VTSAX (Vanguard Total Stock Market Index Fund Admiral Shares):

Modern Portfolio Theory (MPT):

MPT is built on the following key principles:

1. Diversification: MPT emphasizes the importance of spreading investments across a range of asset classes (such as stocks, bonds, real estate) to reduce risk. Diversification helps minimize the impact of poor-performing assets on the overall portfolio.

2. Risk and Return: MPT recognizes that investors seek to maximize returns while minimizing risk. It quantifies risk as the volatility or standard deviation of an asset's returns over time. Investors are expected to choose portfolios that offer the highest expected return for a given level of risk.

3. Correlation: MPT takes into account the correlation between assets. Assets with low or negative correlations can provide better diversification benefits because they tend to move differently in response to market conditions.

4. Efficient Frontier: MPT aims to identify the optimal portfolio mix that provides the highest expected return for a given level of risk or the lowest level of risk for a given expected return. This is represented graphically as the efficient frontier.

VTI (Vanguard Total Stock Market ETF) and VTSAX (Vanguard Total Stock Market Index Fund Admiral Shares):

Both VTI and VTSAX are investment options provided by Vanguard, a well-known investment management company. They are popular among investors for several reasons:

1. Broad Market Exposure: VTI and VTSAX both offer exposure to the entire U.S. stock market. They include a wide range of companies, from large-cap to small-cap, providing diversification across various sectors.

2. Low Costs: Vanguard is known for its low-cost investment options. VTI and VTSAX have low expense ratios, meaning they charge very minimal fees compared to many other funds. This can be appealing to investors looking to minimize costs.

3. Passive Indexing: Both VTI and VTSAX are passively managed funds that aim to replicate the performance of a specific index (in this case, the CRSP US Total Market Index). This approach typically results in lower turnover and lower tax implications compared to actively managed funds.

4. Liquidity: ETFs like VTI can be bought and sold throughout the trading day, while mutual funds like VTSAX are traded at the end of the trading day at the net asset value (NAV). This liquidity can be attractive to traders.

5. Historical Performance: These funds have historically provided competitive returns and have a long track record of performance.

Many investors are drawn to VTI or VTSAX as core holdings in their portfolios because they offer a simple and cost-effective way to gain exposure to the U.S. stock market while adhering to the principles of Modern Portfolio Theory. However, it's important to note that while these funds can be an excellent choice for many investors, the suitability of any investment depends on an individual's financial goals, risk tolerance, and overall investment strategy. It's best to consult with a financial advisor or conduct thorough research before making investment decisions.

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