Modern Portfolio Theory

Modern Portfolio Theory: MPT Definition

Modern Portfolio Theory (MPT) is an investing model where the investor attempts to take minimal level of market risk to capture maximum-level returns for a given portfolio of investments. However, although widely used within the financial industry, there are recent criticisms and variations of style to consider before applying MPT to your own investment portfolio and strategy.

Markowitz, in a 1952 paper published by The Journal of Finance, first proposed the theory as a means to create and construct a portfolio of assets to maximize returns within a given level of risk, or to devise one with a desired, specified and expected level of return with the least amount of risk.

He wanted to eliminate "idiosyncratic risk," or the risk inherent in each investment because of the investment's own unique characteristics.

Markowitz theorized that investors could design a portfolio to maximize returns by accepting a quantifiable amount of risk. In other words, investors could reduce risk by diversifying their assets and asset allocation of their investments using a quantitative method.

With a well-balanced and calculated portfolio, if some of the assets fall due to market conditions, others should rise an equal amount in compensation, according to MPT.

Markowitz demonstrated that, by taking a portfolio as its whole, it was less volatile than the total sum of its parts.

To begin with, Markowitz assumed that most investors are, in their hearts, risk-averse. That means they are more personally comfortable with less risk, and nervous and anxious with increased risk. This also translates into the belief that it is better to not lose money than to find or gain it.

So, given a choice between a higher return possibility with greater risk, and a lower return possibility with less risk, most people will naturally prefer the portfolio with the least risk, even if it means a lower return.

The investor then naturally views a correlation between increased risk and potential higher returns as compensation.

This gets to the heart of Markowitz's theory. Given two portfolios, an investor will naturally prefer one that indicates the highest return possibility with the least risk.

Portfolio Selection, the original title of his ground-breaking theory, was published in March 1952 in and anxious with increased risk. This also translates into the belief that it is better to not lose money than to find or gain it.

So, given a choice between a higher return possibility with greater risk, and a lower return possibility with less risk, most people will naturally prefer the portfolio with the least risk, even if it means a lower return.

The investor then naturally views a correlation between increased risk and potential higher returns as compensation.

This gets to the heart of Markowitz's theory. Given two portfolios, an investor will naturally prefer one that indicates the highest return possibility with the least risk.

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Portfolio Selection, the original title of his ground-breaking theory, was published in March 1952 in The Journal of Finance, published by the American Finance Association. In it, Markowitz argued that portfolios should optimize expected return relative to volatility. He considered volatility could be measured as the variance of return. He suggested also a limit he called the "efficient frontier."

In it, he notes, "the process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with relative beliefs about future performances and ends with the choice of portfolio."

"Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim," he added.

The gist of this selection method is that a portfolio's assets must be selected on the basis of how each asset will impact others as the overall value of the portfolio changes.

Why Is Modern Portfolio Theory Important?

So, when your financial adviser or you decide to have a "diversified portfolio," with assets divided up by percentage in different instruments and sectors -- such as 60% equities (40% large-cap, 20% small-cap), 20% commodities, and 20% fixed income -- that's Modern Portfolio Theory. Also, when you have to manage your own portfolio of investments, whether they be mutual funds or specific securities within your 401K, it helps to know a bit about allocation of your investments versus allocation or calculation of the risks.

Most advisers and even fund managers will do much of the work for you, which is why it is harder to try and do it yourself. For example, in making decisions for investing in a company-provided 401(k), often the manager of the overall portfolio of your choices will provide at the very least the stock or mutual fund's previous return history, and compare it with market returns, to help you, the individual investor, decide how to allocate your investments.

A good broker or financial adviser will ask you what you think is your "risk profile" -- how much risk are you willing to take to get how big a return on your investment? Generally speaking, younger investors can "tolerate" more risk, because they'll have more time to make back money lost in a downturn; older people, especially living on a fixed income have far less risk tolerance, because they might not have the time on earth it may take to recover from a downturn.

Examples of Applying Modern Portfolio Theory

One example of applying MPT relates to a portfolio's expected return. MPT shows that the overall expected return of a portfolio is the weighted average of the expected returns of the individual assets themselves. For example, assume that an investor has a two-asset portfolio worth $1 million. Asset X has an expected return of 5%, and Asset Y has an expected return of 10%. The portfolio has $800,000 in Asset X and $200,000 in Asset Y. Based on these figures, the expected return of the portfolio is

Portfolio expected return = (($800,000 / $1 million) x 5%) + (($200,000 / $1 million) x 10%) = 4% + 2% = 6%

If the investor wants to ratchet up the expected return of the portfolio to 7.5%, all the investor needs to do is shift the appropriate amount of capital from Asset X to Asset Y. In this case, the appropriate weights are 50% in each asset:

Expected return of 7.5% = (50% x 5%) + (50% x 10%) = 2.5% + 5% = 7.5%

This same idea applies to risk. One risk statistic that comes from MPT, known as beta, measures a portfolio's sensitivity to the market's systematic risk, which is the portfolio's vulnerability to broad market events. A beta of one means that the portfolio is exposed to the same amount of systematic risk as the market. Higher betas mean more risk, and lower betas mean less risk. Assume that an investor has a $1 million portfolio invested in the following four assets:

Asset A: Beta of 1, $250,000 invested

Asset B: Beta of 1.6, $250,000 invested

Asset C: Beta of 0.75, $250,000 invested

Asset D: Beta of 0.5, $250,000 invested

The portfolio beta is:

Beta = (25% x 1) + (25% x 1.6) + (25% x 0.75) + (25% x 0.5) = 0.96