The Modern Portfolio Theory

What is Modern Portfolio Theory?

Modern Portfolio Theory (MPT) is a framework for analyzing and constructing portfolios that attempts to maximize return for a given level of risk. It was developed by Harry Markowitz in the early 1950s and published in his groundbreaking 1952 paper "Portfolio Selection."

While MPT has come under criticism in recent years, it remains the most widely used approach to portfolio construction and asset allocation. In this article, we'll take a closer look at how MPT works and some of its key drawbacks.

How MPT Works

The central tenet of MPT is that risk is inherent in all investments and that it should be accounted for when constructing a portfolio. Markowitz showed that by diversifying across different asset classes, investors could minimize risk while still achieving their desired return targets.

This diversification is achieved by holding a mix of assets that are not perfectly correlated with each other. For example, stocks and bonds tend to move in opposite directions, so holding both asset classes can help dampen the overall volatility of a portfolio. Correlation measures how closely two asset classes move to each other. A positive correlation means that when one asset class goes up, the other asset class also goes up. A negative correlation means that when one asset class goes up, the other asset class goes down. And a correlation of 0 means that there is no relationship between the two asset classes.

The risk is calculated by taking the standard deviation of the historical return of the assets in the same period.

Markowitz also introduced the concept of "efficient frontiers," which are curves that show the optimal trade-off between risk and return for a given set of assets. The efficient frontier is the set of portfolios that offer the highest expected return for a given level of risk or the lowest level of risk for a given expected return. Investors can use the efficient frontier to choose the portfolio that best meets their needs.

Image Credit: Wikipedia

For example, suppose Portfolio A has an expected return of 12% and a standard deviation of 10%. Assume that Portfolio B has an expected return of 12% and a standard deviation of 15%. Portfolio A would be deemed more efficient because it has the same expected return but lower risk.

Drawbacks of MPT

Despite its widespread use, MPT has come under fire in recent years for several reasons.

  • First, it relies on historical data to estimate future returns, which may not be accurate.
  • Second, it assumes that markets are efficient, which means that prices reflect all available information and that it's impossible to beat the market. This assumption has been shown to be false in many studies.
  • Finally, MPT assumes that investors are rational and make decisions based on maximizing utility, which is often not the case in real life.

Modern Portfolio Theory has come under fire in recent years for its role in the financial crisis. Critics argue that MPT doesn't adequately account for risk, leading investors to make poor decisions. As a result, some have called for a new approach to investing that takes risk into account.


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