Modern Portfolio Theory

An investment theory that allows investors to assemble a portfolio of assets that maximizes expected return for a given level of risk

What is Modern Portfolio Theory?

Harry Markowitz was the founder of Modern Portfolio Theory which forms the foundation of investment literature. The Modern Theory assumed that the returns are always normally distributed, which means investors are only concerned about the means and variance of the returns. It also assumes that investors are rational and risk-averse. Another assumption of the theory is that capital markets are perfect, and investors don’t pay any commission or taxes.

The Modern Portfolio Theory (MPT) refers to an investment theory that allows investors to assemble an asset portfolio that maximizes expected return for a given level of risk. The theory assumes that investors are risk-averse; for a given level of expected return, investors will always prefer the less risky portfolio.

Hence, according to the Modern Portfolio Theory, an investor must be compensated for a higher level of risk through higher expected returns. MPT employs the core idea of diversification – owning a portfolio of assets from different classes is less risky than holding a portfolio of similar assets.

Why is it important to know This Theory?

This theory forms the foundation of all investment models such as CAPM. Hence, one can’t understand these investment models without understanding the Theory. 

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.

How Modern Portfolio Theory Works

Modern portfolio theory helps investors minimize market risk while maximizing return. It starts with two fundamental assumptions:

You cannot view assets in your portfolio in isolation. Instead, you must look at them as they relate to each other, both in terms  potential return and the level of risk each asset carries. When you look at a portfolio as an organic whole, you can select different assets whose performances aren’t correlated in order to balance the risk offered by each choice. It’s very difficult to forecast future investment returns. Instead, investors should look backwards at long-term historical returns to approximate how various investments might perform in the future.

With these principles in mind, investors proceed by modeling a range of different portfolios with varying levels of risk and expected returns. To simplify a bit, investors multiply the percentage each asset occupies in a model portfolio by the level of risk or returns it’s expected to deliver. Add up the percentage-adjusted risk levels for the total portfolio risk and the percentage-adjusted expected returns and you have the portfolio’s expected return.

Modern Portfolio Theory Example

Here’s a very basic look at how modern portfolio theory could be used in practice. Consider a $1 million portfolio that’s split between $700,000 in Fund A and $300,000 in Fund B. Fund A has an expected return of 7% while Fund B has an expected return of 10%.

Fund A has an expected value of (0.70)(0.07) or 0.049

Fund B has an expected value of (0.30)(0.10) or 0.030

Add the expected returns of each fund to arrive at the portfolio’s expected value, which is 7.9%

Once you’ve determined a portfolio’s overall level of risk and returns, you can construct what’s called an efficient frontier to figure out what a risk-optimized portfolio would be for the returns you want.

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.

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. 

What MPT Means for You

Modern portfolio theory has had a marked impact on how investors perceive risk, return, and portfolio management. The theory demonstrates that portfolio diversification can reduce investment risk. In fact, modern money managers routinely follow its precepts. Passive investing also incorporates MPT as investors choose index funds that are low cost and well-diversified. Losses in any individual stock are not material enough to damage performance due to the diversification, and the success and prevalence of passive investing is an indication of the ubiquity of modern portfolio theory. 

The gist of MPT is that the market is hard to beat and that the people who beat the market are those who take on above-average risk. It is also implied that these risk-takers will get their comeuppance when markets turn down.

Then again, investors such as Warren Buffett remind us that portfolio theory is just that—theory. At the end of the day, a portfolio’s success rests on the investor’s skills and the time that they devote to it. Sometimes it is better to pick a small number of out-of-favor investments and wait for the market to turn in your favor than to rely on market averages alone.