learn
Investing

The Basics of Modern Portfolio Theory, Explained

Investing

Mins Read 3

img

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.

Never miss a thing!

news and markets updates

* Terms apply

Raseed Invest Limited © 2021 - All Rights Reserved.

Raseed Invest Limited (“Raseed”) registered in the Dubai International Financial Centre (“DIFC”) and is regulated by the Dubai Financial Services Authority (“DFSA”) to conduct financial services “Arranging Deals in Investments” with a 'Retail' endorsement. Raseed does not provide any trading or investment advice and shall not be responsible for any loss arising from any investment based on any general information provided by Raseed or as may be available on Raseed’s website and other web-based services (collectively, the “Website Services). Raseed does not warrant that the information is accurate, reliable or complete or that the supply will be without interruptions. Any third party information provided through does not reflect the views of Raseed.

The content of the Website Services provided by Raseed is only intended to provide you with general information and is neither an offer to sell nor a solicitation of an offer to purchase any security and may not be relied upon for investment purposes. Any commentaries, articles, daily news items, public and/or private chat publications, stock analysis and/or other information contained in the Website Services should not be considered investment advice.

Raseed shall not be liable for any delay, inaccuracy, error or omission of any kind in the information provided by Raseed and/or any third party information provider or for any resulting loss or damage you may suffer as a result of or in connection with the information supplied by Raseed and/or any third party information provider. In addition, Raseed shall have no liability for any losses arising from unauthorized access to information or any other misuse of information.

Any opinions, news, research, analysis, prices, or other information contained on our Website Services or emailed to you are provided as general market commentary, and do not constitute investment advice. Raseed will not accept liability for any loss or damage, including, without limitation, for any loss of profit which may arise directly or indirectly from use of or reliance on such information. Each decision as to whether an investment is appropriate or proper, is an independent decision by you. You agree that Raseed has no fiduciary duty to you and is not responsible for any liabilities, claims, damages, costs and expenses, including attorneys’ fees, incurred in connection with you following Raseed’s generic investment information. Raseed makes no representations as to whether a particular investment is appropriate or suitable for you.


View important disclosures