The Basics of Modern Portfolio Theory, Explained


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New to the U.S. stock market? Here's a fun fact. Modern portfolio theory, or MPT, is a concept of investing that was first described in a paper for the Journal of Finance in 1952. Harry Markowitz published this key work on modern portfolio theory that explained his strategy to design the most efficient and effective investment portfolio.

Markowitz shared the 1990 Nobel Prize in Economic Sciences for his contributions to the investment world. Today, modern portfolio theory continues to influence investors. 

How does modern portfolio theory work?

Modern portfolio theory offers a quantitative method for minimizing risk and diversifying investments. It addresses two risk categories: systematic and unsystematic risk. 

Systematic risks are things you can't prevent through diversifying, like interest rate changes, inflation, wars, and recessions.

Unsystematic risks are specific to individual stocks. Events like changes in executive leadership at a company or decreases in operations can be unsystematic risks, and investors can hedge against these risks through diversification. 

By using MPT, investors can lower the volatility that comes from investing in only one asset class. 

MPT involves plotting a combination of different assets (stocks, bonds, securities) on a graph. 

Along the X-axis is the risk of each asset, and along the Y-axis, the expected returns on each asset. The efficient frontier is an upward-sloping curve that connects the portfolios with the greatest efficiency. Keep your investments above that curve for the optimum results in MPT. 

Problems with modern portfolio theory

Modern portfolio theory doesn't solve every issue for investors. Some people believe actively managing a portfolio is more effective than the buy-and-hold strategy of MPT. 

Here are some other faults with modern portfolio theory: 

  • It's based on expected returns rather than real data, so results may not meet expectations. 

  • It assumes different assets will respond independently to market shifts. However, investments don't always respond independently, so it's possible that two or more very different assets will drop in value after a market event. 

  • You may need to take on a seemingly risky investment in order to minimize your overall risk through MPT.

Some have adapted Markowitz's strategy to create post-modern portfolio theory (PMPT). Post-modern portfolio theory takes the core of MPT and changes the way it defines risk. Investors using the post-modern version aim to incorporate negative returns in their portfolio calculations. They may be more inclined to actively manage their investments.

Is modern portfolio theory still relevant? 

Some critics say modern portfolio theory has grown outdated. Still, its tactics of buying and holding a diverse selection of assets is useful for many investors who would not do well in a more actively managed investment style. 

Although no one can create an entirely risk-free portfolio, many investors prefer a more passive investment strategy. That's why low-cost funds are so popular. Even robo-advisors, which trade based on algorithms, exist largely due to modern portfolio theory.

Learn more about diversification on the Raseed blog and get educated about the US stock market.

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