What is Modern Portfolio Theory?
Modern Portfolio Theory (MPT) is an investing model in which investor 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.
According to the modern portfolio theory, all the investments that are selected are combined together in a way that it reduces the risk in the market through the means of diversification and at the same time also generates the good return in the long term to the investors.
Example of the Modern Portfolio Theory (MPT)
There is an individual who wants to invest in a portfolio. He got an option of two portfolios which are as follows:
- 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, differed usually between -5 % and + 25 %).
- 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, differed usually between 7 % and 13 %)
According to modern portfolio theory which investment portfolio the person should consider?
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- 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 differs usually between -5 % and + 25 %.
- On the other side in 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 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 of Modern Portfolio Theory
Modern Portfolio theory has the certain assumption that is to be considered while making any decisions in order to arrive at the conclusion that risk, return and the diversification relationships hold true. The different assumptions of the modern portfolio theory are as follows:
- Returns from the assets are distributed normally.
- The investor making the investment is rational and will avoid all the unnecessary risk associated.
- Investors will give his best in order to maximize returns for all the unique situations provided.
- All investors are having access to the same information.
- The cost pertaining to the taxes and trading is not considered while making decisions
- All the investors are having the same views on the rate of return expected.
- The single investors along are not sizeable and capable enough for influencing the prices prevailing in the market.
- Unlimited capital at the risk-free rate of return can be borrowed.
Advantages of the Modern Portfolio Theory (MPT)
There are several different advantages of the 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 evaluation and in managing risks and returns associated with the investments. With the help of analysis, the assets which are under-performing assets and the assets having an excessive risk with respect to returns can be scrutinized and then replaced with the new one.
- The theory is an important tool for avoiding the financial ruin because by following these theory 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 of the Modern Portfolio Theory (MPT)
Along with the different advantages, there exist the limitations and drawbacks also of the Modern portfolio theory which includes the following:
- In the case of the modern portfolio theory, past performance of the company under consideration is taken. The performance of the past never provides the guarantee for the result that could arise in the future. Considering only the past performances sometimes leads to over passing of the newer circumstances which might not be there when historical data were considered but could play an important role in taking the decision.
- 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 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.
The main idea or the purpose of the Modern portfolio theory says that the risk undertaken and return expected is 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. 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.
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. However, regardless of the different criticism Modern portfolio theory is a working strategy having a diversified investment which is implemented by different risk managers, investment institutions and related persons.
This has been a guide to Modern Portfolio Theory (MPT) and its definition. Here we discuss key assumptions of Modern Portfolio Theory along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –