Modern Portfolio Theory

Updated on April 26, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Modern Portfolio Theory?

An investment model like modern portfolio theory or MPT allows investors to choose from a variety of investment options consisting of a single portfolio for earning maximum benefits and that too at a market risk which is way lower than the various underlying investments or assets.

Modern Portfolio Theory Definition

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The main idea or the purpose of the Modern portfolio theory says that the risk is undertaken and returns are linked directly, which means that in order to achieve the greater rate of expected returns, an investor must have to take a higher level of risk. Also, the theory says that the overall risk of the portfolio having securities can be reduced through the means of diversification.

Key Takeaways

  • Modern Portfolio Theory (MPT), developed by Harry Markowitz, is an investment approach that focuses on diversification and the relationship between risk and return when constructing investment portfolios.
  • MPT suggests that by combining assets with different risk and return characteristics, investors can optimize their portfolios to achieve maximum expected returns for a given level of risk or minimize risk for a desired level of return.
  • The efficient frontier, a key concept in MPT, represents the set of portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of expected return.

Modern Portfolio Theory Explained

Modern Portfolio Theory (MPT) is an investing model in which investors invest with the motive of taking the minimum level of risk and earning the maximum amount of return for that level of acquired risk. The modern portfolio theory is a helpful tool for the investors as it helps them in choosing the different types of investments for the purpose of the diversification of the investment and then making one portfolio by considering all the investments.

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According to modern portfolio theory, all the investments that are selected are combined together in a way that reduces the risk in the market through the means of diversification and, at the same time, also generates a good return in the long term to the investors.

In case two different portfolios are given to the investor having the same level of expected return, then the rational decision would be to choose the portfolio having lower total risk.

Even though it is accepted widely all over the world and also applied by different investment institutions, but at the same time, there are also some modern portfolio theory criticism by different persons. However, regardless of the different criticisms, Modern portfolio theory is a working strategy having a diversified investment that is implemented by different risk managers, investment institutions, and related persons.

Modern Portfolio Theory

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Example

There is an individual who wants to invest in a portfolio. He got an option of two portfolios, which are as follows:

  1. The first portfolio consists of a mix of the bonds and different stocks that gave the return of 10 % annually on an average, but at the same time differed by the range of as much as 15 % annually (returns, in this case, usually differed between -5 % and + 25 %).
  2. On the other hand, the second portfolio consists of a mix of the bonds and different stocks that gave the return of 10 % annually on an average, but at the same time differed by a range of only 3 % annually (returns, in this case, usually differed between 7 % and 13 %).

According to the modern portfolio theory graph, which investment portfolio should a person consider?

Analysis

  • In both scenarios, the average expected return on the investment is 10 %. However, in the first portfolio, one could get the return of as much as 25 %, which sounds attractive, but at the same time, there prevails a huge risk where one might lose 5 % as well because the range usually differs between -5 % and + 25 %.
  • On the other hand, in the case of the second portfolio, a less return range of between 7 % and 13 % may be less attractive to the investor, but in that case, it is expected that one will not lose his money, which makes the investment less risky than the first portfolio.
  • According to the modern portfolio theory graph, an investor invests with the motive of taking the minimum level of risk and earning the maximum amount of return with that minimum risk taken, so in the present case, one should choose the second portfolio as he is getting the same average expected return with the less level of risk.

Assumptions

Modern Portfolio theory has a certain assumption that is to be considered while making any decisions in order to arrive at the conclusion that risk, return, and diversification relationships hold true. The different assumptions of the modern portfolio theory are as follows:

  • Returns from the assets are distributed normally. Due to this assumption, various statistical measures like standard deviation or correlation in analysis or portfolio can be used.
  • The theory assumes that the investor making the investment is rational and will avoid all the unnecessary risk associated. This implies that any decision maker who acts in a rational manner will have the aim of maximising the utility and will evaluate their investments based on the return and risk associated with it. It also leads to the fact that all information collected is relevant to the process.
  • Investors will give their best in order to maximize returns for all the unique situations provided.
  • All investors have access to the same information. Even though this is assumed, such a situation is not always realistic.
  • The cost pertaining to taxes and trading is not considered while making decisions. The theory assumes that there is no tax or any kind or transaction cost while holding the asset of transacting with it.
  • All the investors are having the same views on the rate of return expected. . Thus, all investors have same expectations about the return that they will get in future, the volatility of the asset value or correlation within assets. Therefore, it offers a consistent framework.
  • The single investors alone are not sizable and capable enough to influence the prices prevailing in the market. There are a number of investors and all of them are equally important in the process.
  • Unlimited capital at the risk-free rate of return can be borrowed.
  • It does not account for the market fluctuations or changes in the economic conditions. It assumes that the characteristics of return from the market remains unchanged.

Advantages

There are several different importance of modern portfolio theory providing the opportunity for the investors investing their money in the market. Some of the advantages are of the Modern portfolio theory as follows:

  • It helps in evaluating and managing risks and returns associated with the investments. With the help of analysis, the assets which are underperforming assets and the assets having an excessive risk with respect to returns can be scrutinized and then replaced with the new one.
  • The importance of modern portfolio theory lies in the fact that it is an important tool for avoiding financial ruin because by following these theories, traders don’t rely on only one investment for their financial stability; rather, they diversify their portfolio in order to get the maximum return with minimum risk.

Disadvantages

Along with the different advantages, there modern portfolio theory criticism, which includes the following:

  • In the case of the modern portfolio theory, the past performance of the company under consideration is taken. The performance of the past never provides a guarantee for the result that could arise in the future. Considering only the past performances sometimes leads to overpassing the newer circumstances, which might not be there when historical data were considered but could play an important role in making the decision.
  • Another limitations of modern portfolio theory is that this theory assumes that there is a normal distribution of the return on an asset within a class of assets, which is proved to be wrong for individual equities as the correlations of asset class may change over the period of time.
  • In this theory, there is an assumption that securities of any of the sizes can be bought and sold, which doesn’t hold true as some of the securities have minimum order sizes, which cannot be dealt with in the fraction.
  • Modern Portfolio Theory even though is accepted widely all over the world and also applied by different investment institution, but at the same time it has also been criticized by different persons particularly by representatives of the behavioral economics who challenges the assumptions of the Modern portfolio theory on the parameters of investor rationality and the expectations for the return.

Thus, while studying, analysing or implementing, it is necessary to understand both the advantages and the limitations of modern portfolio theory.

Modern Portfolio Theory Vs CAPM

Both the above concepts have very close relation with each other in the financial field, but they have some important difference between them, as given below:

  • The former focusses on how to construct a portfoilio by considering the return and risk of every asset in it, where the latter focusses on what will be the return on a portfolio by determining how sensitive the assets are to the market risk and the risk-free rate of return.
  • The former deals with the risk and return of every asset in the investment whereas the latter deals with only the return.
  • The former assumes that all investors are risk averse and rational, and the latter assumes the cases of the former and adding to it the market is in equilibrium.

Thus, the above are some differences between the two concepts.

Frequently Asked Questions (FAQs)

1. Who gave modern portfolio theory?

Modern Portfolio Theory (MPT) was developed by Harry Markowitz, an economist, and Nobel laureate, in 1952. He introduced the theory in his paper titled “Portfolio Selection,” which revolutionized the field of investment management. Markowitz’s work provided a mathematical framework for analyzing risk and return in investment portfolios.

2. What are the applications of modern portfolio theory?

Modern Portfolio Theory has several applications in finance and investment management. First, it helps investors optimize their portfolio allocation by considering the risk and return trade-offs. Second, MPT assists in diversifying investments to reduce risk, constructing efficient portfolios that maximize returns for a given level of risk, and analyzing the performance of investment portfolios based on their risk-adjusted returns.

3. How does MPT handle the trade-off between risk and return?

Modern Portfolio Theory (MPT) handles the trade-off between risk and return using mathematical models and statistical analysis. MPT seeks to optimize portfolio allocation by balancing the expected return of an investment against its risk. By diversifying investments across different asset classes with varying risk levels, MPT aims to maximize returns for a given level of risk or minimize risk for a desired level of return.

This has been a guide to what is Modern Portfolio Theory (MPT). We explain it with example assumptions, differences with CAPM, advantages & disadvantages. You can learn more about accounting from the following articles

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