Modern Portfolio Theory (MPT)
A portfolio that provides a given level of return for the lowest possible risk.
Harry Markovitz, an American economist, is the founder of the Modern Portfolio Theory. In his 1952 paper "Portfolio Selection," Markovitz postulated that investors are risk averse. As a result, they always try to attain their desired level of return by assuming the lowest possible risk.
It is a fact that high-risk investments yield higher returns, while low-risk investments have low yields. Therefore, striking a balance by combining these two in varying quantities can help construct an optimal portfolio.
That is a portfolio that gives the highest possible return for a given level of risk. Or vice versa, a portfolio that provides a given level of return for the lowest potential risk.
Constructing a portfolio of investments with varying levels of risk is the best approach for diversifying risk. MPT helps investors find the best portfolio for optimizing their returns on investment.
Modern Portfolio Theory remains one of the most widely employed tools for risk assessment of investment portfolios by asset managers and investors.
A mathematical framework that uses mean-to construct investment portfolios that can provide optimal returns for a given level of risk.
MPT suggests that a more holistic approach can be useful rather than viewing an individual investor's risk and return attributes. Instead, each investment in a portfolio must be seen as merely a part of the whole portfolio.
The contribution from each investment and its movements relative to others in the mix are defining factors for an effective portfolio. Such a varied mix of investments hedges unnecessary risk associated with the investment.
This way, even when one investment incurs a loss, the others may make up for it by growing by a greater percentage than the loss. The net return on the portfolio, therefore, remains positive.
Despite being used for several decades, the Modern Portfolio Theory has some limitations that leave it wanting further refinement.
The Modern Portfolio Theory uses variance as a measure of risk; variance merely shows the stock price dispersion around its mean value. That dispersion may mean large losses that occur rarely or smaller losses that are more frequent.
To an investor, the latter is preferable, as smaller losses are easier to overcome. However, he won't be able to make that distinction based on interpretations from the MPT, as it will show both portfolios to be equally favorable.
The theory needs to reveal the circumstances and amounts of losses that the variance represents. Considering downside risk as a more credible measure of the probability of incurring losses may remedy this problem.
The entire focus of the Modern Portfolio Theory is to diversify risk. The fact that an investor may have to undertake investments whose risk is greater than his threshold to satisfy the overall level of risk in a portfolio is often overlooked.
Investors may not entirely be willing to attain such stock when made aware of the true nature of risk. While constructing a portfolio, MPT does not provide the number of investments that make up an optimal portfolio. Investment experts have a wide spectrum of views on this matter.
Some believe that not even one hundred stocks can eliminate unsystematic risk and achieve an optimal portfolio. At the same time, some think that little more than twenty choices are enough to have a reasonably diversified portfolio.
The efficiency frontier seems like a very effective tool for picking out an optimized portfolio. However, finding out the values and plotting them is a daunting task best left to sophisticated computer programs.
Even if an investor manages to overcome all these problems, there still remains the unresolved matter of systematic risk. Diversification can only eliminate risks specific to the assets in a portfolio or unsystematic risks.
or idiosyncratic part of risk alone cannot guarantee an efficient portfolio.
The estimates used by Modern Portfolio Theory are largely based on historical data. Historical data cannot be used to represent future trends; therefore, the results rendered through MPT are often inapplicable to real-world conditions.
It seems logical to invest in a risk-free asset by borrowing money to increase the overall return on a portfolio. However, the task of finding a truly risk-free asset is impossible.
Treasury bills may seem virtually risk-free as they have no default risk. However, they are not immune to other kinds of changes that may cause risk. These may be price changes leading to inflation or changing interest rates.
The age-old saying "not keeping all your eggs in one basket" forms the underlying principle for diversification.
Diversification is hedging avoidable risks from an investment portfolio by including investments from different sectors and industries and finding the best fit for a.
Accordingly, a portfolio of low-risk investments might satisfy the investors' risk threshold. However, the returns it provides might need to be revised. Similarly, a portfolio of high-risk investments will have a higher rate of return but at a risk level that would be irrational to undertake.
Also, investing in similar types of investment or similar business sectors is never recommended, as each has a cycle. A real estate investor, for example, may have to bear heavy losses if he's invested all his money in real estate while property prices are declining.
He might make up for those losses during a boom, but there is a lower chance that he still wants to invest after suffering such losses.
A diversified portfolio ensures that the investments are varied enough to attain positive gains despite the phase of business of one particular asset.
A strategic combination of high and low-risk investments that preferably move in opposite directions would offset losses with gains.
Such a combination is an optimal portfolio in which all idiosyncratic risk has been eliminated, and the investor earns a higher rate of return at a relatively lower risk level.
We have talked vastly about diversified portfolios and how they help eliminate risk; however, it is impossible to eliminate risk from an investment. This is because not all risks in investing can be avoided by diversification.
Based on the nature of risk, there are two classifications:
The risk affects the entire market. It is inherent in any business or investment. It exists beyond the control of any organization or individual. It is a non-diversifiable risk.
Fluctuating rates of interest and inflation are examples of systematic risk.
2. Unsystematic Risk
Also sometimes known as idiosyncratic risk, it is the risk associated with a particular type of asset, such as. Such risk can be eliminated to an extent with the help of diversification.
Organizational factors like change in leadership or short sales are part of unsystematic risk. The investor can construct a portfolio of assets to protect against unsystematic risks.
Correlation, Variance, And Standard Deviation
The statistical measures of correlation, variance, and standard deviation of the investments in a portfolio are determining factors for a diversified investment position.
Shows the relationship between two investments. This relationship may be positive; when, in response to movements in the market, one investment grows, and so does the other.
Or negative; when one investment gains, the other incurs a loss. That is, they move in opposite directions to one another.
The value of correlation lies between -1 and +1. If the correlation between two investments is -1, they have a perfect negative correlation. Conversely, a correlation coefficient of +1 suggests a perfect positive correlation.
The purpose of diversification is to have a portfolio with a negative correlation coefficient. That way, we can have an optimized portfolio with maximum diversification.
Determines the returns' volatility or tendency to spread around the mean. This is a measure of risk whereby the more spread out the return values are, the greater the risk associated with that investment. High variance equals higher-risk assets.
3. Standard deviation
Attained by taking the square root of variance.
Having understood diversification, we can now see the most beneficial diversification for an investment portfolio. An efficient frontier is a graphical representation of the risk-return relationship of risk-optimized portfolios.
The ultimate objective of an investor is to earn the highest possible return for a given level of risk tolerance. This is where the efficient frontier provides answers to these questions.
The line, which is the efficient frontier, represents a set of efficient portfolios. Efficiency here means that for a given level of risk, there is a portfolio that provides the highest return. Conversely, for a given level of return, one portfolio offers the lowest chance.
We get a parabolic curve by plotting all these efficient portfolios on the graph, with return on the y-axis and risk on the x-axis. Any portfolios that lie on this curve or above it are considered to be risk-optimized.
All portfolios lying below the efficient frontier either give too little return for the assumed risk or pose too high a chance for the recovery earned to be sound investments.
A rational investor would only invest in portfolios on or above the efficient frontier. His portfolio's position on the border will be determined by the level of risk he is willing to undertake or the kind of return he would like to achieve.
The Modern Portfolio Theory and the Post Modern Portfolio Theory operate on the basic principle of diversifying investment portfolios to hedge all unsystematic risk.
They do so by combining investments that are negatively correlated with one another. In this way, while in a portfolio, the gains from one may offset the losses incurred by another, and the net return may still be positive.
The Modern Portfolio Theory, despite its popularity, has some limitations. Some of these were addressed in 1991 by Brian M. Rom and Kathleen Ferguson. They were software engineers who noted discrepancies in the software that was based on the MPT.
They realized two important drawbacks to using the Modern Portfolio Theory;
- The investment returns of all securities and portfolios can not be credibly obtained from a normal distribution.
- Using variance as a measure of risk associated with an investment ignores the downside risk it may have.
So instead of variance, the Post Modern Portfolio Theory employs downside risk to factor risk into diversification and notes its impact on the returns of investments. It squares the sum of all negative returns; and takes the standard deviation of the negative returns as a standard measure of risk.
Santino's ratio replaced's ratio for calculating risk-adjusted returns. This helped rank investments better in terms of their risk versus return tendencies.
Modern Portfolio Theory (MPT) FAQs
The basic concept that founded the theory is that a portfolio's combined risk and return hold more importance than that of a singular investment. By having an understanding of this idea, an investor can construct portfolios that are diversified and have multiple asset classes.
Such a portfolio allows extracting maximum return for the investor's given level of risk.
MPT is still used to understand the importance of diversification while making investments. However, the theory relies heavily on assumptions that render the results it produces unfit for use in real-world scenarios.
It can be used in conjunction with behavioral finance to understand why the market exhibits anomalies.
Also, the theory only considers the effect that markets have on investments. It ignores any impact the investment may have on the market, such as the index effect.
Henry Markovitz founded the MPT. Hewho wrote a paper in 1952 on portfolio selection. This paper became the foundation for deriving the theory as we know it today. He was awarded the Nobel Prize for efforts in this regard.