What is Modern Portfolio Theory?
The stock market is a trade off between risk and reward — the level of reward you can expect often has a strong correlation with the level of risk you’re willing to accept. High risk investments are known for high returns, while low-risk investments generate lower returns.
Traditionally, investors gauge each investment by the risk-versus-reward profile of the investment itself. The Modern Portfolio Theory turns that idea on its head.
This theory suggests that investments should be chosen based on how they will affect the risk-and-reward profile of your investment portfolio as a whole, rather than the risk-and-reward metrics associated with each single investment.
What Is Modern Portfolio Theory (MPT)?
The Modern Portfolio Theory, or MPT, is a model for portfolio selection developed and published in the Journal of Finance by American economist Harry Markowitz in 1952. Markowitz was later awarded the Nobel Prize for his work on the theory.
The theory assumes that all investors are risk-averse investors in the sense that if there is a way to generate higher returns with less risk, the option would be appealing to investors. That assumption has proven true time and time again.
Assuming all investors are risk averse means there’s no need to consider an individual’s risk tolerance while choosing investments to add to your portfolio. Instead, using MPT, investors should look for the assets that will either increase return potential, reduce risk, or both when added to a diversified portfolio.
The optimal portfolio under this investment strategy includes a mix of high-risk and low-risk investments, balanced in a way that provides the most volatility protection and the highest potential return. The goal is achieving higher returns while accepting lower overall portfolio risk.
Multiple asset classes are used when building a portfolio, with a special focus on their variance and correlation:
- Variance. Variance measures the difference between numbers in a dataset. Variance is used to gauge risk by determining the spread between the worst possible outcome (risk) and the best possible outcome (reward).
- Correlation. Correlation refers to how two or more assets react with each other. For example, Treasury bonds have a positive correlation with gold because both assets are known to increase in value under similar circumstances — when one goes up, usually so does the other, and vice versa. But Treasuries have a negative correlation with stocks, meaning when Treasury bonds are up, stocks tend to trend down, and vice versa.
Considering the above, say you have a portfolio built of nothing but Treasury bonds. Your portfolio would be low risk, but would have limited upside potential. At the same time, Treasury bonds are likely to fall when the market is performing well. Your risk-reward profile in an all-bond portfolio is suboptimal.
Under the Modern Portfolio Theory, your portfolio could benefit greatly from a small allocation to high-risk, high-reward equities like small-cap value stocks. These stocks are known for heavy levels of volatility and are significantly riskier than Treasury bonds on an asset-to-asset basis.
However, by adding a 10% allocation of small-cap value stocks to a Treasury bond-heavy portfolio, you actually reduce total portfolio risk while increasing your earnings potential.
That’s because Treasury bonds will move up and down, but at a slower pace and in a different direction than stocks. When your bond holdings are down, your small-cap value stock holdings will likely pick up the slack and potentially provide substantial gains. On the flip side, when the stocks in the portfolio are down, the Treasury bonds pick up the slack.
On the other side of the coin, say you have a portfolio built of 100% stocks. Although your return potential would be relatively high, your risk will also be high. By mixing in a small amount of Treasury bonds, you’ll greatly reduce the risk associated with market volatility while limiting the downward drag on your potential gains.
How Does Modern Portfolio Theory Model the Relationship Between Risk and Reward?
Modern Portfolio Theory is a common method for diversification, with an idea called the efficient frontier at its core. The efficient frontier is a line that’s created when plotting multiple portfolios on a chart and drawing an upward sloping line connecting them.
An investor looking to find the efficient frontier starts by building multiple portfolios, comparing them to each other on the basis of risk — or the annualized standard deviation of the portfolio — and reward as measured by the compound annual growth rate (CAGR) of the portfolio.
For example, say Portfolio A has an annualized standard deviation of 8% and a CAGR of 9.5%, while Portfolio B has an annualized standard deviation of 9.5% and a CAGR of 9.5%, and Portfolio C has a standard deviation of 6% and a CAGR of 8%.
Using these figures to draw the efficient frontier of these portfolios, you would plot them on a chart using the X axis for risk and the Y axis for reward. Draw a line through the middle of the plotted points and you’ll find an upward-sloping efficient frontier.
As you plot the risk and reward of additional portfolios, you’ll add more points to your chart, with the efficient frontier being the average or center line cutting through the points you plot. Some of the portfolios you chart will sit above and to the left of the efficient frontier while others fall below and to the right. The goal is to build a portfolio that lands above the efficient frontier line, maximizing returns with the minimum necessary risk.
When choosing which portfolio you’ll invest in based on the efficient frontier, portfolios toward the right of the chart will come with greater risk in relation to the returns you’ll generate, while the portfolios on the left will come with lower levels of risk.
Pros and Cons of Modern Portfolio Theory
As with any other investment strategy, MPT comes with benefits and drawbacks.
Pros of Modern Portfolio Theory
Investment strategies don’t result in Nobel Prizes often. It’s clear that there’s a lot to gain from following the MPT. Some of the most exciting benefits include:
- Stronger Portfolio Returns. Your goal when you invest is to make money. This strategy is designed to help investors increase their earnings potential in the stock market.
- Lower Risk. By diversifying your portfolio with multiple negatively correlated assets, you’ll greatly reduce the impact of volatility on your investments, resulting in reduced risk.
- Emphasis on Diversification. Most professionals recommend diversified investment portfolios because they act as insurance, helping to make sure you don’t lose too much money if things go wrong. Due to its strong emphasis on diversification, this strategy provides a significant level of safety.
Cons of Modern Portfolio Theory
Although there are plenty of benefits, there are also risks to consider before employing the MPT in your investment portfolio:
- Variance Over Investment Risk. The MPT measures variance rather than downside risk. This means two portfolios with the same variance and returns are treated the same. However, it also means one portfolio that sees small declines relatively often is treated the same as one that sees significant declines on a relatively rare basis. For most investors, a portfolio with smaller declines is the better option because a large, random drop in value is too painful and can result in emotional investing. So, even though MPT measures both portfolios the same, one is clearly the more risky portfolio.
- Technical Knowledge. In order to use this strategy, investors must have some technical knowledge, including an understanding of concepts like standard deviation, asset collections, and compound annual growth rate. As a result, it’s a cumbersome strategy for newcomers.
Modern Portfolio Theory (MPT) vs. Post-Modern Portfolio Theory (PMPT)
MPT was built on the idea that an investment portfolio should include a mix of low- and high-risk assets. The theory also suggests any assets added to the portfolio should increase its potential returns while avoiding increases to its overall risk.
The Post-Modern Portfolio Theory, or PMPT, doesn’t argue these concepts, but it does look at risk in a different way.
For example, in the Modern Portfolio Theory, several small declines that equal up to a 10% decline are the same as a 10% drop in a single day. However, stocks that experience such declines are highly volatile and should be avoided by most investors.
In the PMPT, risk is viewed asymmetrically, with larger potential declines weighing more into the risk equation than frequent smaller declines.
Should You Use Modern Portfolio Theory to Model Risk and Reward?
Although the MPT was developed and published in 1952, it’s still highly relevant today. In fact, the vast majority of investors are already investing based on the core premise of the theory.
When you start investing, you’re often told to keep a close eye on asset allocation, mixing stocks and bonds to ensure a safe, yet prosperous investment portfolio. Stocks are inherently the high-risk asset, while bonds provide stability with low-risk allocation.
This is the basic premise on which robo-advisors and many widely accepted investment strategies work.
The only difference is that when you actively practice MPT, you ensure any investments you add land above the efficient frontier explained above. Just about every investor will benefit from doing this if they are able.
MPT Frequently Asked Questions
Any time a financial concept becomes popular, many investors will have questions and want to know more. The Modern Portfolio Theory is no different.
Here are commonly asked questions about MPT and the answers you’re likely looking for:
What Are the Benefits of Modern Portfolio Theory?
Following this investment strategy comes with a few core benefits. First and foremost, the strategy was designed to result in a portfolio that offers the highest potential returns with the lowest necessary risk.
You’re in the market to make money, not lose it. So, following a portfolio strategy that’s known for both growing the value of your investments and protecting them from market risks is a compelling idea.
Moreover, the strategy hammers home the value of diversification, setting the stage for success.
What Is a Key Difference Between Modern Portfolio Theory and Traditional Portfolio Theory?
The traditional portfolio theory is the method of investing most new investors follow. It’s the basic idea that you should pay attention to the risk-and-reward profile of each and every individual investment and only invest in assets that are within your personal risk tolerance.
With the MPT, the investment assessment is based on how the investment will affect the risk-and-reward profile of the entire portfolio as a whole. In some cases, investments you wouldn’t make following the traditional portfolio theory are prime candidates to add when following the MPT.
What Are the 2 Key Ideas of Modern Portfolio Theory?
This investment strategy gets its backbone from two key ideas:
- Risk vs. Return. This theory stipulates that a portfolio’s total risk-and-reward profile is more important than the risk-and-reward profile of any individual asset.
- Action. Knowing the key idea surrounding risk and return, investors are able to take action and build a successful investment portfolio that’s based in diversification and provides lower risk and higher returns overall.
Any time you invest, the balance of risk and reward should always be a consideration. There’s no such thing as a risk-free investment. Even if you were to hold all of your money in cash, you risk losing purchasing power thanks to changes in exchange rates and inflation.
MPT addresses the risk-and-reward balance in a relatively easy-to-understand way. By investing in negatively correlated assets that reduce the risk of volatility while exposing your portfolio to potential rewards, you’ll be on your way to a secure financial future.