Modern portfolio theory is an investment theory with one major assumption - most investors are risk averse. The assumption of the theory is that most investors want the maximum return or reward for the least amount of risk.
Many investments fall into one of two buckets. They are high risk but offer the potential for high return or they are low risk but offer a lower return. The theory states that by
allocating dollars across a mix of both high and low risk assets, investors can achieve the maximum return for their individual
risk tolerance.
The theory was orginally developed in the 1950s in order to push investors away from a focus on individual investments towards a portfolio constructed of a variety of assets. The theory uses what is called the efficient frontier to demonstrate the ideal relationship between risk and reward.
The efficient frontier is simply a graph that demonstrates the relationship between the risk and reward of a portfolio and aims to show the most efficient version of a portfolio given a specified amount of risk. The shape of the efficient frontier should form a parabola after completion.
Any point on this line shows an efficient portfolio given the level of risk the investor is willing to take. Any point that it is behind the frontier is not efficient and should likely not be used by an investor. The risk would need to be reduced or the return increased for the portfolio to be efficient according to MPT and the efficient frontier.
Here is a practical example of MPT in action. An investor is looking to build a portfolio between two investment funds. First is Fund A which is an
index fund and the second is Fund B which is a
bond fund. This investor is looking to invest $10,000.
Assume that fund A (which may be riskier to invest in) can provide an average return of 10% per year while Fund B (which may be more stable) can provide an average return of 5% per year. If this investor was more aggressive they may
allocate 90% of their $10,000 towards Fund A and the remaining 10% towards Fund B.
Fund A has an expected value of 0.09 (10% return x 90% allocation) and Fund B has an expected value of 0.005 (5% return x 10% allocation). This would give this portfolio an expected return of 9.5% (0.09 + 0.005). This investor is willing to take on more risk in exchange for this higher return.
If the asset allocation was adjusted, the expected return would also be adjusted. These hypothetical returns for different asset allocation would be used to create the efficient frontier. The MPT states that asset allocation is a key (although not the only one) to creating efficient portfolios that provide the maximum return for a given level of risk.
Investment portfolios are common practice nowadays. Many investors today would agree that finding the proper balance between risk and reward is common sense. However, it wasn't always like this. If we rewind time back to the 1930s risk was not the primary concern when investing.
Instead, price was. The goal was simply to buy good stocks at the best price. The term "best price" is a bit of a loose term as many investors of the time did not have sufficient information to gauge whether a stock was truly at its best price.
John Burr Williams summed up the investment theories of the time in his book The Theory of Investment Value in 1938. This leads us to Harry Markowitz. Markowitz was a 25 year old graduate student in search of a topic for his doctoral theosis.
After a chance encounter with a stock broker, Markowitz decided to write on the market and read John Williams' book. After doing so, he was shocked by the fact that risk was not considered for a given investment.
This led Markowitz to write Portfolio Selection which was published in the Journal of Finance in March of 1952. The article did not catch fire right away but later became a vital investing principle that stated that risk and not price should be the key factor when constructing portfolios.
For the everyday investor, modern portfolio theory can provide an intelligent framework for creating their ideal investment portfolio. As a whole, the theory focuses on investing concepts such as
asset allocation,
risk tolerance and
diversification.
These concepts have become common practice among modern investors and for good reason. The reality is that most investors will not be able to be more efficient than a given market and do need to have a plan in place to manage the inherent risk of investing.
Although modern portfolio theory is not perfect, it may be a good place to start for the everyday investor who lacks the investing knowledge or experience to generate returns or choose investments that will be more efficient than building a portfolio based on MPT.
Although modern portfolio theory has become increasingly popular, it is not without criticism. The first major criticism is that the hypothetical returns that are used to plot the efficient frontier for different asset allocations of a particular portfolio are often based on historical data which may not reflect real world scenarios.
For example, say that you are looking to create a portfolio consisting of 3 different investment funds. The historical returns for these funds are 10%, 8.5%, and 4.5%. If you use these hypothetical returns and different asset allocations, you can plot the efficient frontier.
However, if the real world returns of the portfolio moving forward differ from the historical returns, the portfolio may not be as efficient as originally assumed under the MPT. The second major criticism of MPT is that the theory evaluated portfolios based upon variance and not downside risk.
In other words, two portfolios could have the same level of variance and be equally desirable under the MPT. However one of these portfolios may have frequent small losses while the other has less frequent but significant losses.
For many investors, having frequent but smaller losses may be easier to tolerate than larger infrequent losses. This goes to show that the MPT can provide a good framework for many investors, but it is not an absolute or perfect law - it is just a theory.
Like almost all questions in finance, the answer is that it depends. As previously stated, the theory is a great starting place for the everyday investor. It will force you to find the appropriate balance between risk and reward for your desired level of return.
If you do not have vast investing experience or knowledge, violating the theories of the MPT will likely only cause harm and no good. This is not to say that the MPT is perfect, but it is a well thought out investing philosophy for most people.
This is not to say that by any stretch of the imagination you have to follow the theory. There are plenty of critics of the theory that can poke holes in Markowitz's argument. Your primary focus when investing should be suitability.
Not only do you want to find investments that are suitable for your goals, but your overarching investing theory should also be suitable for you. This may or may not include the use of MPT. If you need help to implement the theory, it is a good idea to work with a financial professional such as a
financial advisor.
The bottom line is that MPT was created by Harry Markowitz in 1952 to articulate that investors are risk averse and want the maximum return for the least amount of risk. The theory aimed to push investors away from a focus on individual assets and towards a portfolio of various asset classes.
Markowitz theorized that investors should aim to build their portfolios based around their risk tolerance and not simply focus on the "best price" of an asset. The theory has its flaws, but does provide a useful framework for the average investor to have success over the long term.
