What Is Modern Portfolio Theory?
Modern Portfolio Theory (MPT) is an investing methodology for choosing investments within a portfolio that maximizes returns while avoiding unnecessary risk. This is done through diversification of investments across sectors, asset classes, and through negative correlation.
Modern portfolio theory is designed to help investors develop efficient portfolios based on expected returns and risk tolerance. Finding the “efficient frontier” is the cornerstone of modern portfolio theory, and uses diversified portfolio construction to achieve the highest average returns for a given level of risk.
Who Developed Modern Portfolio Theory?
Modern Portfolio Theory was originally presented by Harry Markowitz in the Journal of Finance in 1952 in a piece called “Portfolio Selection.”[1] In it, Markowitz detailed the processes of selecting investments in a diversified portfolio with respect to expected returns and risk. Markowitz was later awarded the Nobel Prize for his development of modern portfolio theory.
How Is Modern Portfolio Theory Useful?
Modern portfolio theory helps investors create an asset allocation strategy for building an investing portfolio that achieves desired returns with a tolerable amount of risk. This is done through investing diversification, not just of owning multiple assets, but also assets spread across less-correlated asset classes, effectively lowering a portfolio's risk, while still producing acceptable returns.
What Are the Key Ideas of Modern Portfolio Theory?
Modern portfolio theory helps marry the relationship between risk and expected return while choosing investments for a portfolio. It argues that constructing a portfolio of diversified assets (e.g. not in the same asset class) will provide greater returns without increasing the level of risk. To take it a step further, modern portfolio theory asserts that including non-correlated assets within an investment portfolio helps lower the overall volatility.
Here are the main ideas beyond MPT as an investment strategy:
Diversification
A core tenant of modern portfolio theory is diversification. This is based on the idea that investing in a single asset (such as a company stock) carries with it a much higher risk than spreading your money across multiple assets (such as dozens of different company stocks). Diversification within an asset class helps lower an investment portfolio’s concentration, while still maintaining a similar expected return.
In addition to diversification within an asset class, owning investments in multiple asset classes gives investors a more broadly diversified portfolio, especially when adding assets beyond traditional stock and bond markets. This may include owning assets in commodities, real estate, gold or other alternative investments (such as collectibles or cryptocurrency).
Are you diversified? Consider real estate with REITS or Crowdfunding.
Risk and Return
MPT explores the relationship between risk and return, and seeks to maintain high returns while simultaneously lowering the overall risk of a portfolio. This is achieved through diversification, particularly by investing in multiple asset classes.
Risk is quantified by calculating the standard deviation of the underlying assets within the portfolio. In short, it’s the amount a given investment can deviate from its average return over time.
The goal of modern portfolio theory is to lower the overall variance of a portfolio from its average returns, ultimately lowering the risk within the portfolio while still achieving a high expected return.
Correlation
One of the main ways MPT lowers risk is by constructing a portfolio of non-correlated assets, or inversely-correlated assets. This is achieved by building an investment mix that includes multiple asset classes, some with negative correlations to each other (such as stocks and bonds). This can be achieved by investing in individual assets (such as individual stocks or real estate properties), but most modern portfolios achieve this by investing in exchange-traded funds (ETFs).
What Are the Biggest Benefits of MPT?
Modern portfolio theory simultaneously lowers investment portfolio volatility (and risk), while maintaining higher expected returns. This is done through investment diversification, as well as asset class diversification. One of the best benefits of MPT is less portfolio drawdown, due to the nature of holding non-correlated (or negatively-correlated) assets that balance each other out during market volatility. This can also be done within an asset class, such as holding individual stocks in different market sectors, or more broadly by investing in different asset classes.
For example; Holding a percentage of your portfolio in stocks (equities), and some percentage in bonds, can help balance overall volatility. When stocks decline, bonds may go up in value, and vice versa, when bonds decrease in value, stocks may increase. This inverse correlation lowers the overall swings in a portfolio’s value, thus reducing the risk.
Bottom line: Modern portfolio theory allows investors to lower the volatility within an investment portfolio without diminishing the overall returns.
Is MPT Still Relevant Today?
With the advent of ETFs, modern portfolio theory is even more relevant today, with easier access to a broad range of investments within a single fund. Investing in a portfolio of ETFs within a wide range of asset classes is possibly the simplest way to employ MPT. In fact, some of the top-ranked robo-advisory services automate this strategy, including Wealthfront and Betterment.
With more investment choices available today than any time in history, and with the advent of new asset classes (such as cryptocurrency), MPT helps investors build a wholly-diversified portfolio.
Summary
Modern portfolio theory has helped investors embrace a diversified investing strategy, which has lowered overall portfolio risk while still providing acceptable returns. With the emergence of ETFs and easier access to a wide range of asset classes, MPT is as relevant today as it has ever been. It has informed the last 70 years of investing, and continues to provide a robust framework for garnering the highest returns for any level of risk.
Need help? Check out the best robo advisors to get started.
