What Is Modern Portfolio Theory (MPT)?

What Is Modern Portfolio Theory (MPT)?

I'm going to explain Modern Portfolio Theory, or MPT, directly to you. It's a mathematical framework I use to build a portfolio of assets that maximizes the expected return for your chosen level of risk. This theory was pioneered by American economist Harry Markowitz in his 1952 paper 'Portfolio Selection,' published in the Journal of Finance. He even won a Nobel Prize for it.

A core element here is diversification. You know most investments are either high risk with high return or low risk with low return. Markowitz showed you can get the best results by mixing them optimally, based on your own risk tolerance.

Understanding the Modern Portfolio Theory (MPT)

Let me break this down for you. MPT argues that you shouldn't view any investment's risk and return in isolation. Instead, evaluate how it affects your entire portfolio's risk and return. This way, you can build a portfolio of multiple assets that gives greater returns without higher risk.

Alternatively, if you start with a desired expected return, you can construct a portfolio with the lowest possible risk to achieve it. Based on stats like variance and correlation, the performance of a single investment matters less than its impact on the whole portfolio.

Acceptable Risk

MPT assumes you're risk-averse, meaning you'd prefer a less risky portfolio over a riskier one for the same return. Practically, this means you should invest in multiple asset classes.

The expected return of your portfolio is a weighted sum of the individual assets' returns. For example, if you have four equally weighted assets with expected returns of 4%, 6%, 10%, and 14%, your portfolio's expected return is (4% × 25%) + (6% × 25%) + (10% × 25%) + (14% × 25%) = 8.5%.

Your portfolio's risk comes from each asset's variance and the correlations between pairs. For a four-asset portfolio, you need the variances and six correlation values. Due to correlations, the total risk is lower than a simple weighted sum.

Benefits of MPT

MPT is useful if you're building diversified portfolios. The rise of ETFs has made it more relevant, giving you easier access to various asset classes.

For instance, if you're a stock investor, reduce risk by allocating some to government bond ETFs. Their negative correlation with stocks lowers your portfolio's variance, and it doesn't hurt expected returns much.

Looking for a Negative Correlation

You can also reduce volatility in a U.S. Treasury portfolio by putting 10% into a small-cap value index fund or ETF. Small-cap value stocks are riskier alone but perform well during high inflation when bonds suffer, lowering overall volatility and boosting expected returns.

MPT lets you construct efficient portfolios. Plot all combinations on a graph with risk on the X-axis and return on the Y-axis to find the best ones. Suppose Portfolio A has 8.5% return and 8% standard deviation, while Portfolio B has 8.5% return but 9.5% deviation—A is more efficient.

Connect the most efficient portfolios with an upward-sloping curve called the efficient frontier. Investing below it doesn't maximize returns for the risk.

Criticisms of the MPT

The biggest criticism is that MPT evaluates portfolios by variance, not downside risk. Two portfolios with identical variance and returns are seen as equal, even if one has frequent small losses and the other rare big drops. You'd likely prefer the small losses.

Post-Modern Portfolio Theory (PMPT) improves on this by focusing on minimizing downside risk instead of variance.

MPT vs. Post-Modern Portfolio Theory

MPT was a breakthrough. It shows you, as a conservative investor, can do better with a mix of low-risk and riskier investments than all low-risk. Importantly, this doesn't add overall risk—that's diversification's key.

PMPT doesn't contradict MPT's basics but adjusts the risk evaluation to fix perceived flaws. Followers of both use platforms to build portfolios matching their risk levels.

How Do Regular Investors Apply Modern Portfolio Theory in Their Personal Investment Strategy?

You can apply MPT by assessing your risk tolerance and creating a diversified portfolio across assets like stocks, bonds, and real estate with low correlations. This isn't about picking winners but balancing the mix. Investing in target-date mutual funds or diversified ETFs means the managers handle some of this for you.

What Are the Benefits of the Modern Portfolio Theory?

MPT diversifies your portfolio for better returns without extra risk. It reduces volatility by choosing negatively correlated assets, like U.S. Treasurys and small-cap stocks.

What Is the Importance of the Efficient Frontier in the MPT?

The efficient frontier is key—it's the line showing investments with the highest return for the lowest risk. If your portfolio is to the right, it has too much risk for the return; below the slope, it underperforms on return for the risk.

The Bottom Line

Before MPT, you might have vaguely known not to put all eggs in one basket. Now, with MPT, you can be precise about risks and rewards of diversification. It's foundational for retail investors, institutions, and high-net-worth individuals in allocating capital.