Modern Portfolio Theory: What MPT Is and How Investors Use It

What Is the Modern Portfolio Theory (MPT)?

The modern portfolio theory (MPT) is a practical method for selecting investments in order to maximize their overall returns within an acceptable level of risk. This mathematical framework is used to build a portfolio of investments that maximize the amount of expected return for the collective given level of risk.

American economist Harry Markowitz pioneered this theory in his paper "Portfolio Selection," which was published in the Journal of Finance in 1952. He was later awarded a Nobel Prize for his work on modern portfolio theory.

A key component of the MPT theory is diversification. Most investments are either high risk and high return or low risk and low return. Markowitz argued that investors could achieve their best results by choosing an optimal mix of the two based on an assessment of their individual tolerance to risk.

Understanding the Modern Portfolio Theory (MPT)

The modern portfolio theory argues that any given investment's risk and return characteristics should not be viewed alone but should be evaluated by how it affects the overall portfolio's risk and return. That is, an investor can construct a portfolio of multiple assets that will result in greater returns without a higher level of risk.

As an alternative, starting with a desired level of expected return, the investor can construct a portfolio with the lowest possible risk that is capable of producing that return.

Based on statistical measures such as variance and correlation, a single investment's performance is less important than how it impacts the entire portfolio.

Acceptable Risk

The MPT assumes that investors are risk-averse, meaning they prefer a less risky portfolio to a riskier one for a given level of return. As a practical matter, risk aversion implies that most people should invest in multiple asset classes.

The expected return of the portfolio is calculated as a weighted sum of the returns of the individual assets. If a portfolio contained four equally weighted assets with expected returns of 4%, 6%, 10%, and 14%, the portfolio's expected return would be:

• (4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%

The portfolio's risk is a function of the variances of each asset and the correlations of each pair of assets. To calculate the risk of a four-asset portfolio, an investor needs each of the four assets' variances and six correlation values, since there are six possible two-asset combinations with four assets. Because of the asset correlations, the total portfolio risk, or standard deviation, is lower than what would be calculated by a weighted sum.

Benefits of the MPT

The MPT is a useful tool for investors who are trying to build diversified portfolios. In fact, the growth of exchange-traded funds (ETFs) made the MPT more relevant by giving investors easier access to a broader range of asset classes.

For example, stock investors can reduce risk by putting a portion of their portfolios in government bond ETFs. The variance of the portfolio will be significantly lower because government bonds have a negative correlation with stocks. Adding a small investment in Treasuries to a stock portfolio will not have a large impact on expected returns because of this loss-reducing effect.

Looking for Negative Correlation

Similarly, the MPT can be used to reduce the volatility of a U.S. Treasury portfolio by putting 10% in a small-cap value index fund or ETF. Although small-cap value stocks are far riskier than Treasuries on their own, they often do well during periods of high inflation when bonds do poorly. As a result, the portfolio's overall volatility is lower than it would be if it consisted entirely of government bonds. Moreover, the expected returns are higher.

The modern portfolio theory allows investors to construct more efficient portfolios. Every possible combination of assets can be plotted on a graph, with the portfolio's risk on the X-axis and the expected return on the Y-axis. This plot reveals the most desirable combinations for a portfolio.

For example, suppose Portfolio A has an expected return of 8.5% and a standard deviation of 8%. Assume that Portfolio B has an expected return of 8.5% and a standard deviation of 9.5%. Portfolio A would be deemed more efficient because it has the same expected return but lower risk.

It is possible to draw an upward sloping curve to connect all of the most efficient portfolios. This curve is called the efficient frontier.

Investing in a portfolio underneath the curve is not desirable because it does not maximize returns for a given level of risk.

Criticism of the MPT

Perhaps the most serious criticism of the MPT is that it evaluates portfolios based on variance rather than downside risk.

That is, two portfolios that have the same level of variance and returns are considered equally desirable under modern portfolio theory. One portfolio may have that variance because of frequent small losses. Another could have that variance because of rare but spectacular declines. Most investors would prefer frequent small losses, which would be easier to endure.

The post-modern portfolio theory (PMPT) attempts to improve modern portfolio theory by minimizing downside risk instead of variance.

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