Modern Portfolio Theory (MPT) is a transformative strategy for selecting investments that aim to maximize overall returns within an acceptable level of risk. This mathematical framework is designed to help investors build portfolios that maximize expected returns on a collective basis while maintaining a balance between various levels of risk.
Pioneered by American economist Harry Markowitz in his 1952 paper “Portfolio Selection”, MPT has become a foundational concept in finance, earning Markowitz the Nobel Prize. A core principle of this theory is the diversification of investments to minimize risk.
Key Takeaways
- Modern Portfolio Theory (MPT): A tool for risk-averse investors to build diversified portfolios that maximize returns without exceeding acceptable levels of risk.
- Portfolio Construction: MPT assists investors in creating efficient portfolios using various asset classes, including ETFs.
- Diverse Goals: Investors deeply concerned with downside risks might find the Post-Modern Portfolio Theory (PMPT) more suited for their needs.
Understanding the Modern Portfolio Theory (MPT)
MPT posits that an investment’s risk and return should be considered in the context of the entire portfolio. It suggests that an investor can construct a portfolio that yields higher returns without higher risk or achieve a particular return with the least possible risk.
Metrics such as variance and correlation are used to evaluate a single investment’s impact on the overall portfolio’s performance. Thus, the collective performance is valued more than individual investments.
Acceptable Risk
MPT operates on the assumption that investors are inherently risk-averse, preferring less risky portfolios over riskier ones for the same rate of return. Practically, this encourages investing across multiple asset classes.
For instance, if a portfolio contains four equally weighted assets with expected returns of 4%, 6%, 10%, and 14%, the portfolio’s overall expected return would be:
(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%.
The risk of the portfolio is a function of each asset’s variance and correlations between assets, often resulting in a total portfolio risk lower than a simple weighted sum.
Benefits of MPT
MPT is particularly useful for investors aiming to create diversified portfolios. The growth of exchange-traded funds (ETFs) has made implementing MPT easier, giving investors broader access to various asset classes.
For example, stock investors might reduce risk by incorporating government bond ETFs, significantly lowering variance because of the negative correlation between government bonds and stocks. Similarly, including small-cap value stocks in a U.S. Treasury portfolio can reduce overall volatility.
Looking for Negative Correlation
MPT allows plotting all possible investment combinations on a risk-return graph, helping investors find the most efficient portfolios. The optimum ’efficient frontier’ identifies portfolios that offer maximum returns for a given level of risk.
For example, consider two portfolios, A and B. If both have an expected return of 8.5%, but Portfolio A has a standard deviation of 8% while Portfolio B has 9.5%, Portfolio A is more efficient as it offers the same return with lower risk.
Criticism of MPT
A major critique of MPT is its evaluation of portfolios based solely on variance, overlooking downside risk. Portfolios with the same variation and returns are equally desirable in MPT, regardless of the nature of their losses.
Post-Modern Portfolio Theory (PMPT) addresses this by focusing on minimizing downside risk instead of variance, making it a potential alternative for concerned investors.
Frequently Asked Questions
What Is the Difference Between Modern Portfolio Theory and Post-Modern Portfolio Theory?
MPT suggests a balanced mix of low-risk and higher-risk investments can deliver better returns without added risk. PMPT builds on MPT by modifying how risk is evaluated, particularly by focusing on downside risk.
What Are the Benefits of Modern Portfolio Theory?
MPT diversifies your portfolio to yield better returns without increasing risk. Investing in negatively correlated assets can reduce volatility substantially.
What Is the Importance of the Efficient Frontier in MPT?
The efficient frontier represents the optimal combinations of investments that offer the highest returns for the least risk. Investing in portfolios aligned with the efficient frontier is crucial for realizing the benefits of MPT.
Related Terms: Efficient Frontier, Post-Modern Portfolio Theory, investment risk, portfolio variance.
References
- Harry Markowitz. Portfolio Selection. The Journal of Finance, Volume 7, No. 1, 1952, Pages 77-91.
- The Nobel Prize. “This Year’s Laureates Are Pioneers In The Theory of Financial Economics and Corporate Finance”.
