Modern Portfolio Theory

What Is It?

Modern Portfolio Theory (MPT) was developed in the 1950s by Harry Markowitz. It helped change the way investors view building an investment portfolio to help meet their financial objectives. Before MPT, investors often focused on trying to pick individual stock “winners” to achieve their investment goals. However, given the risk of owning a portfolio of just a few stocks, and the difficulty involved in picking stocks that could outperform the market, this approach was not suitable for delivering consistent results. Modern Portfolio Theory demonstrated that by diversifying your investments across many stocks, you could significantly reduce risk while still earning the higher long-term returns typically associated with stocks.

MPT focuses on overall portfolio risk and expected return rather than the risk and return characteristics of each individual stock in a portfolio. The theory demonstrates that a portfolio containing a variety of assets can be designed to offer an investor maximum returns for a specified level of risk based on historical performance data. Similarly, at an expected return level, a portfolio can be built having the lowest possible amount of risk

MPT describes how investors can build portfolios that provide an optimal amount of expected return for a specified level of market risk. The theory is based on the assumption that higher risk is linked to higher returns. For any particular level of risk, the theory holds, an “efficient frontier” can be calculated. The efficient frontier curve derived from these calculations displays the optimal portfolio mix, representing the highest level of return, for a given level of risk at each point on a graph.

Modern Portfolio Theory assumes that investors will select a less risky portfolio over a riskier portfolio if both portfolios have the same expected return. An investor would be expected to take on additional risk only in situations where doing so would be expected to lead to greater returns.

How Is It Used?

The main idea behind MPT is that an investor should use diversification when building an investment portfolio with the goal of minimizing risk and maximizing reward. According to the theory, the stocks that make up your portfolio should be different enough from each other to optimize portfolio balance. For instance, a portfolio containing only high-tech stocks would likely not be as balanced as one that contained a basket of stocks from a variety of industries. Additionally, diversification among different geographical markets and asset classes can provide even greater protection from market volatility.

Other Considerations

It is worth noting that MPT is that it is based on historical data. Thus, if market conditions in the future diverge from those of the past, the performance of asset classes may also diverge from past patterns.

Caution should also be used in trying to apply MPT yourself, rather than working with a digital asset manager service or investment advisor, if you are not familiar with the assumptions and calculations underlying the theory. There are many anecdotal points that are often overlooked by an average investor when it comes to applying the theory. Investment advisors have the relevant expertise and specialists who look to best utilize MPT along with other relevant theories.