What Is Modern Portfolio Theory (MPT)?

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DEFINITION

Modern portfolio theory (MPT) is an investing strategy that minimizes market risk while maximizing returns. It is based on the premise that markets are efficient, and it utilizes diversification to spread investments across different assets.

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 decline, the bond investments would still earn interest and experience less volatility, offsetting, in part, the market risk of the equity portion of the portfolio.

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.

Note

One simple way to remember MPT is that "the whole is greater than the sum of its parts." Risky individual investments do not have to make for a risky portfolio overall.

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 bondss

Note

Suppose you had a portfolio equally split between stocks and bonds. Between 1970 and 2003, it would have produced similar returns at a lower level of volatility and greater diversification than either asset class alone.

Pros and Cons of MPT

Pros
  • No timing the market

  • Suitable for average investor

  • Reduces risk in investing

Cons
  • Not based on modern data

  • Standardized assumptions

Pros Explained

  • No timing the market: Most investors want higher returns for lower risk, but many don't have the time, knowledge, or emotional distance to find success with market timing.
  • Suitable for the average investor: Anyone can benefit from MPT or use its key ideas to achieve a balanced portfolio that is set up for long-term growth.
  • Reduces risk in investing: It's a good idea to spread your investments across assets that aren't positively correlated. That can protect you from changes in the market.

Cons Explained

  • Not based on modern data: The concepts of risk, reward, and correlation that underlie MPT are derived from historical data. This data may not be applicable to new circumstances in the market.
  • Standardized assumptions: MPT functions based on a standardized set of assumptions about market behavior. These might not bear out in a constantly changing financial climate.

Alternatives to MPT

You may feel that knowledge of behavior and price volatility in the market will allow you to make more timely investment decisions. If you are uncomfortable with the buy-and-hold nature of MPT, a tactical asset allocation approach may be an option.

With tactical asset allocation, you can still incorporate the three primary asset classes (stocks, bonds, and cash) into your portfolio. But unlike investors who use MPT, you would then actively balance and adjust the weights (percentages) of the assets. You would do that by using technical and fundamental analysis to maximize portfolio returns and minimize risk compared to a benchmark.

You may find that a combination of the two approaches is the best strategy. For instance, you may often buy and hold assets according to MPT, but you still might take advantage of changes in the market. Perhaps you buy more stocks during a recession, when they are lower in price. You would then hold those assets for a long time; that would allow them to return to their pre-recession levels and increase the value of your portfolio.

You also may form opinions about some sectors in the economy, such as the technology or travel & hospitality industries, and select your favorite stocks in them for a tactical investing layer added on top of a passive long-term MPT strategy.

Key Takeaways

  • Modern portfolio theory is an investing strategy. It focuses on minimizing market risk while maximizing returns.
  • MPT uses diversification to spread investments across different asset classes. That creates higher returns at lower levels of risk.
  • It generally advocates a buy-and-hold strategy with occasional rebalancing.
  • Critics say that MPT is based on historical assumptions that might not always prove correct in modern markets.

Article Sources

  1. Investor.gov. "Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing."

  2. TD Ameritrade. "Modern Portfolio Theory."

  3. University of California, Berkeley. "Modern Portfolio Theory," Page 5.

  4. New York University. "Investing on Hope? Small Cap and Growth Investing," Page 13.

  5. University of California, Berkeley. "Modern Portfolio Theory," Page 7.

  6. MIT. "Modern Portfolio Theory & Equilibrium Asset Pricing," Page 15.