If you’re hitting the gym, you’ve probably heard the mantra, “No pain, no gain.” The same mindset applies to business and investing: taking risks is often necessary for achieving rewards. Generally, higher returns come with higher risks. For instance, the stock market tends to offer better returns than Treasury bonds, though it poses greater risks. But here’s the twist: Modern Portfolio Theory offers a way to enhance returns while reducing risks under certain conditions.

Imagine putting $100 into a bank savings account in the U.S. It’s nearly risk-free, thanks to FDIC insurance guaranteeing your deposit won’t decrease. However, you’ll earn a minimal interest—typically around 0.1%. By year’s end, that means only an extra 10 cents on your initial $100.

Contrast this with investing your money in the U.S. stock market. While the stock market can be volatile, it can also significantly increase the value of your investment. Take 1995, for example—you could have ended up with $138, but in 2008, you might have been left with just $63. Despite these fluctuations, if you leave your money in the stock market over a long period, historical data suggests an average annual return of about 7%. After ten years, your initial $100 could potentially grow to $200, compared to a meager $101.05 in a bank account.

Your investment choice should hinge on your risk tolerance. If the thought of your $100 dwindling to $63 makes you anxious, the stock market might stress you out too much. A savings account, though less profitable, would offer peace of mind.

Now, here’s where Harry Markowitz’s Modern Portfolio Theory comes into play. Developed in 1952, this theory introduces the concept of the efficient frontier, which plots the best possible return for a given level of risk. What’s fascinating is that even with a mix of stocks and bonds, you can actually lower your risk more effectively than with an all-bond portfolio.

When calculating risk, we use the standard deviation from the average return—the larger the deviation, the more volatile the portfolio. If you were to invest 100% in stocks (like an S&P 500 index fund), the risk would be at its highest. As you add bonds—specifically 10-year U.S. Treasury bonds—the portfolio’s overall risk declines. Interestingly, this risk doesn’t decrease in a straight line. There’s a sweet spot of minimal risk, known as the inflection point, which occurs with around 20% stocks and 80% bonds. Even a 25/75 split of stocks and bonds offers lower risk than a 100% bond portfolio.

Why does this happen? Because stocks and bonds generally have an inverse relationship. When one goes up, the other might go down, providing a diversification effect that mitigates risk. This confirms that diversification can effectively lower your investment risk.

So, next time you consider where to park your money, remember: don’t put all your eggs in one basket. Diversify wisely, and you’ll likely find a balance that suits your financial goals and risk tolerance. Happy investing!