Key Takeaways:
- Modern Portfolio Theory (MPT) is a popular, fundamental investing theory.
- MPT advocates for a diversified investment portfolio to achieve an efficient risk-return profile. This is a strategy an average investor can use starting now.
- There are limitations to MPT. There are alternatives and other refined theories. MPT is a starting point.
- At the end of the day, MPT is a theory. A portfolio’s real success depends on more than just statistical analysis.
Modern Portfolio Theory (MPT) was developed by Nobel Laureate Harry Markowitz and has been refined by experts over time. The concepts from MPT serve as the basis of many investment portfolios today. While a deep understanding of MPT may not be necessary, an overview of these concepts can help you build confidence in your investment journey.
Overview of Modern Portfolio Theory
- MPT builds on the risk-return relationship concept that states riskier investments generally means potential for higher returns (and vice versa).
- The theory proves that the risk-return profile of a combination of assets (i.e., a portfolio) is different and more important than the specific risk-return characteristics of any individual piece.
- MPT further demonstrates that this understanding can formulate an “optimal” portfolio for a given risk or return. This means that an investor can build a plan that maximizes returns given specific risk tolerance.
- One of the main reasons what MPT works is because of correlation. Correlation is a measure of how one variable moves in relation to another. Different assets have different return correlations with each other. This characteristic, combined with the differences in risk-return profiles, is fundamental to creating an “optimal” portfolio.
- MPT shows that diversification benefits the investor by improving returns and lowering risks. The risks that diversification reduces are idiosyncratic or unsystematic risks, which are inherent risks involved in an asset due to unique and specific circumstances.
There’s more to MPT than the bullets above. The points above represent the bare-bones of the theory.
How does Modern Portfolio Theory impact your investment strategy today?
This theory is essential whether you are a passive or active investor. Assuming reducing volatility is important to you, it helps you think about how to achieve that goal (hint: through diversification).
It’s worth noting that MPT is incorporated into index funds and mutual funds. The reason these funds are diversified is partially due to the desire to reduce volatility.
Alternatives to Modern Portfolio Theory
While MPT is a popular framework, it does have its critics and limitations.
For example, MPT assumes that the market is efficient, and participants act rationally (i.e., work hard and targeted to maximize returns while lowering risks). Research in behavioral finance has shown that investors sometimes act irrationally.
Another example is how MPT views risk-return and correlation profiles as static characteristics based on historical data. Both risk-return and correlation profiles are not rigid concepts that can be set once and maintained into perpetuity. This assumption has its challenges in a rapidly changing world.
The question becomes: what are the alternatives? There are several, and here are two examples.
- Post-Modern Portfolio Theory (PMPT). In simplified terms, PMTP enhances MPT by introducing a different statistical measurement of risk (i.e., the Sortino ratio) and developing a portfolio based on such metrics.
- Behavioral Finance. MPT assumes an efficient market with rational people. Behavioral Finance does a reality check on MPT by modifying and substituting certain components to introduce “irrationality” and defining risk as failure to reach goals (as real people do). It is a theory that has continued to develop.
All of this is interesting, at best. What does all this mean for you, like actually? We explore this in the next article.
Disclaimer: The contents of this website is an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.