What Is Modern Portfolio Theory (MPT)?

 

Definition and Example of Modern Portfolio Theory

Developed by Nobel Laureate Harry Markowitz, modern portfolio theory is a widely used model. It’s meant to help investors minimize market risk. At the same time, it can maximize their returns. MPT is a theory based on the premise that markets are efficient and more reliable than investors.

You can use MPT to choose the investments in your portfolio. MPT most often promotes a buy-and-hold strategy with occasional rebalancing.

• Alternate name: Mean-variance analysis
• Acronym: MPT

Investing in growth stocks may carry a higher risk of loss when compared to the overall market. As a result, a portfolio might have a portion allocated to bonds. If the stock market and growth stocks, the bond investments would still earn interest and experience less volatility, offsetting, in part, the market risk of the equity portion of the portfolio decline.

Another example involves investing in assets whose prices are negatively correlated, meaning their prices tend to move in the opposite direction. Oil prices and airline stock prices tend to move in the opposite direction. Since airlines use oil as fuel, a rise in oil prices leads to higher costs and lower airline stock prices. Conversely, when oil prices decline, so too do airline fuel costs, leading to higher airline stock prices.

How Modern Portfolio Theory Works

Modern portfolio theory assumes that every investor wants to achieve the highest possible long-term returns without taking extreme levels of short-term market risk. Risk and reward are positively correlated in investing; If you opt for low-risk investments, such as bonds or cash, you can expect lower returns.

You’ll need to invest in investments with more risk, like stocks, to receive higher returns. You might not be willing to take the gamble and put your money into those investments, though. It depends on your comfort level with risk.

The way to overcome this, according to MPT, is through diversification. This theory promotes the spread of money across different asset classes and investments.

MPT says you can hold a certain asset type or investment that is high in risk, but when you combine it with others of different types, the whole portfolio can be balanced. Then its risk is lower than the individual risk of underlying assets or investments. For instance, you wouldn’t hold only risky stocks or only low-return bonds. Instead, you would buy and hold a mixture of both to ensure the largest possible return over time.

Types of MPT Strategies

When choosing investments, your goal shouldn’t be to accept the highest risk to extract the highest returns.

Instead, your portfolio should be on what Markowitz called the “efficient frontier.” This means it should balance risk and reward so that you get the highest return at an acceptable level of risk.

There are a few ways to achieve this goal.

Strategic Asset Allocation

The simplest way to create an efficient portfolio is through a strategic, or passive approach. This is where you buy and hold combinations of assets and investments that aren’t positively correlated. In other words, they don’t move up and down under the same market conditions. You include these in your portfolio in fixed percentages. For instance, as an asset class, stocks are often higher in market risk than bonds. A portfolio consisting of both stocks and bonds may achieve a reasonable return for a relatively lower level of risk.

Stocks and bonds are negatively correlated. As stocks go up in price, bonds tend to go down in price. MPT strategy further minimizes substantial losses in your overall portfolio value when one asset class declines.

On the investment level, foreign stocks and small-cap stocks are often higher in risk than large-cap stocks. MPT allows you to combine all three. You can potentially achieve above-average returns compared to a benchmark such as the S&P 500, all for an average level of risk.

One investment selection governed by MPT might be a portfolio of mutual funds containing:

• 40% large-cap stocks (index)
• 10% small-cap stocks
• 15% foreign stocks
• 30% intermediate-term bonds
• 5% cash/money-market

Even with a strategic asset allocation approach, it’s important to rebalance your portfolio or bring it back to its original asset allocation periodically. That helps you avoid overweighting certain assets and keep your holdings in sync with your investment goals.

Two-Fund Theorem

You don’t need a complex portfolio made up of many investments to comply with MPT. The theory states that you can achieve an efficient portfolio with only two mutual funds. This approach allows you to avoid picking any individual stocks.

This approach might create a two-fund portfolio divided equally between stocks and bonds:

• 50% large-cap, mid-cap, and small-cap stocks
• 50% corporate bonds and short-term, medium-term, and intermediate-term government bonds

Pros and Cons of MPT

• Not based on modern data
• Standardized assumptions