What is Modern Portfolio Theory (MPT)?
Modern Portfolio Theory (MPT) is a practical method of selecting investments to maximize their overall returns within an acceptable level of risk. This mathematical framework is used to build an investment portfolio that maximizes the amount of return expected for a given collective level of risk.
american economistharry markowitzHe pioneered this theory in his article "Portfolio Selection" published in the Journal of Finance in 1952.He later received the Nobel Prize for his work on modern portfolio theory.
A key component of MPT theory is diversification. Most investments are either high risk and high return or low risk and low return.Markowitz arguedthat investors could achieve their best results by choosing an optimal combination of the two based on an assessment of their individual risk tolerance.
main conclusions
- Modern Portfolio Theory (MPT) is a method that risk-averse investors can use to create diversified portfolios that maximize their returns without unacceptable levels of risk.
- Modern Portfolio Theory can be useful to investors trying to build efficient and diversified portfolios using ETFs.
- Investors more concerned with downside risk may prefer Postmodern Portfolio Theory (PMPT) over MPT.
Modern Portfolio Theory (MPT)
Understanding Modern Portfolio Theory (MPT)
Modern portfolio theory argues that the risk and return characteristics of any investment should not be viewed in isolation, but should be evaluated based on how it affects the risk and return of the overall portfolio. That is, an investor can create a portfolio of multiple assets that will generate higher returns without a higher level of risk.
Alternatively, starting with a desired level of expected return, the investor can build a portfolio with the lowest possible risk capable of producing that return.
Based on statistical measures such asdifferencemicorrelation, the return of a single investment is less important than its impact on the entire portfolio.
acceptable risk
MPT assumes that investors are risk averse, which means that they prefer a less risky portfolio to a riskier one for a given level of return. In practice, risk aversion implies that most people should invest in multipleasset classes.
The expected return of the portfolio is calculated asheavysum of returns on individual assets. If a portfolio contains four equally weighted assets with expected returns of 4%, 6%, 10%, and 14%, the portfolio's expected return would be:
- (4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8,5%
Portfolio risk is a function of the variances of each asset and the correlations of each pair of assets. To calculate the risk of a portfolio of four assets, an investor needs each of the variances of the four assets and six correlation values, since there are six possible combinations of two assets with four assets. Due to asset correlations, the total risk of the portfolio orstandard deviation, is less than what would be calculated by a weighted sum.
Benefits of the MPT
The MPT is a useful tool for investors trying to build diversified portfolios. In fact, the growth of exchange-traded funds (ETFs) has made the MPT more relevant by making it easier for investors to access a broader range of asset classes.
For example, stock investors can reduce risk by placing a portion of their portfolios inGovernment Bond ETFs. The portfolio change will be significantly less because government bonds are negatively correlated with stocks. Adding a small Treasury investment to a stock portfolio will not have a large impact on expected returns due to this stop loss effect.
looking for negative correlation
Similarly, the MPT can be used to reduce the volatility of a US Treasury portfolio by putting 10% into asmall cap value index fundor ETFs. Although small-cap value stocks are much riskier than Treasuries alone, they generally do well during periods of high inflation when bonds perform poorly. As a result, the overall volatility of the portfolio is less than it would be if it were made up entirely of government bonds. In addition, the expected returns are higher.
Modern portfolio theory allows investors to create more efficient portfolios. Each possible combination of assets can be plotted on a graph, with portfolio risk on the X axis and expected return on the Y axis. This graph reveals the most desirable combinations for a portfolio.
For example, suppose Portfolio A has an expected return of 8.5% and a standard deviation of 8%. Assume that Portfolio B has an expected return of 8.5% and a standard deviation of 9.5%. Portfolio A would be considered more efficient because it has the same expected return but less risk.
It is possible to draw an upward-sloping curve to connect all the most efficient portfolios. This curve is calledefficient frontier.
Investing in a portfolio below the curve is not desirable because it does not maximize returns for a given level of risk.
Criticism of the MPT
Perhaps the most serious criticism of the MPT is that it values portfolios on the basis of variance rather thannegative risk.
That is, two portfolios that have the same level of variance and returns are considered equally desirable according to modern portfolio theory. A portfolio can have this variation due to frequent small losses. Another might have this variation due to rare but spectacular falls. Most investors prefer frequent small losses, which would be easier to bear.
Opostmodern wallet theory(PMPT) attempts to improve modern portfolio theory by minimizing downside risk rather than variance.
frequent questions
What is the difference between modern portfolio theory and postmodern portfolio theory?
Modern Portfolio Theory (MPT) was a breakthrough in personal investing. This suggests that a conservative investor might be better off choosing a mix of low-risk and riskier investments than choosing low-risk options entirely. More importantly, it suggests that the more rewarding option does not add additional overall risk. This is the key attribute of portfolio diversification.
Opostmodern wallet theory(PMPT) does not contradict these basic assumptions. However, it changes the risk assessment formula on an investment to fix what its developers perceived to be flaws in the original.
Followers of both theories use software that is based on MPT or PMPT to create portfolios that match the level of risk they seek.
What are the benefits of modern portfolio theory?
Modern Portfolio Theory can be used to diversify a portfolio for better overall performance without increased risk.
Another benefit of modern portfolio theory (and diversification) is that it can reduce volatility. The best way to do this is to choose assets that are negatively correlated, such as US Treasuries and small-cap stocks.
Ultimately, the goal of modern portfolio theory is to create the most efficient portfolio possible.
What is the Importance of the Efficient Frontier in the MPT?
The efficient frontier is the cornerstone of modern portfolio theory. It is the line that indicates the combination of investments that will provide the highest level of return for the lowest level of risk.
When a portfolio falls to the right of the efficient frontier, it is riskier relative to its expected return. When it falls below the slope of the efficient frontier, it offers a lower level of return relative to risk.
FAQs
What is MPT and why it is used? ›
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.
What is modern portfolio theory explanation? ›Modern portfolio theory is a method for portfolio management to reduce risk, which traces its origins to a 1952 paper by Nobel Prize winner Harry Markowitz. The theory states that, given a desired level of risk, an investor can optimise the expected returns of a portfolio through diversification.
What is the primary focus of modern portfolio theory MPT )? ›Key Takeaways. Modern portfolio theory (MPT) argues that it's possible to design an ideal portfolio that will provide the investor maximum returns by taking on the optimal amount of risk.
What is modern portfolio theory quizlet? ›Define modern portfolio theory. An investment framework that is useful in diversifying the risk when allocating assets in a financial, liquid (tradable) portfolio in order to maximise the potential return given a specified level of risk appetite or tolerance.
What is the full meaning of MPT? ›MPT - Master of Physical Therapy.
What is modern portfolio theory example? ›Modern Portfolio Theory Assumptions
For example, if two investments yield 10% each but have standard deviation in those returns of 4% and 2%, the risk averse investor would prefer the asset with the 2% variation in return. Risk averse investors also require a premium for taking on more risk.
Modern Portfolio Theory suggests diversification of all your securities and asset classes and not putting all your eggs in one basket. It emphasizes the importance of portfolios, diversification, risk, and the connections among different kinds of securities.
Is modern portfolio theory still useful? ›Modern Portfolio Theory is valid; it is more descriptive rather than prescriptive, but most of the theory relies on assumptions that are often incorrect. Luckily, we have behavioral finance to add some rationality to MPT, reminding us that we can hope the market is stable.
Why modern portfolio theory is widely used in planning investment strategies? ›Modern portfolio theory helps investors minimize market risk while maximizing return. It starts with two fundamental assumptions: You cannot view assets in your portfolio in isolation. Instead, you must look at them as they relate to each other, both in terms potential return and the level of risk each asset carries.
What should an investor's objective be according to the modern portfolio theory? ›According to the tenets of modern portfolio theory, an investor's ideal portfolio will be the one that maximizes their potential for return, while minimizing risk—or at least keeping the portfolio's risk within an acceptable range.
How do you use portfolio theory? ›
- Investors attempt to maximize returns given their unique situation.
- Asset returns are normally distributed.
- Investors are rational and avoid unnecessary risk.
- All investors have access to the same information.
- Investors have the same views on expected returns.
What is a MPT? An MPT is a master's degree in physical therapy. People with a master's in physical therapy often pursue careers that aid in treating patients with physical ailments. While an MPT does not qualify you to be a physical therapist, completing this course of study may help you prepare for a DPT program.
What is the difference between DPT and MPT? ›One of the main differences between the Masters and the Doctor is the duration of the degree. A typical MPT program is two years long with fifteen weeks of clinical experience, which had been the norm for years. In comparison, a typical DPT program is three years long and requires one full year of clinical experience.
What does MPT mean for a physical therapist? ›What does MPT mean? MPT and MSPT stand for Master of Physical Therapy and Master of Science in Physical Therapy. They are earned through an advanced course of study and are the second highest academic degrees held by physical therapists.
Who is eligible for MPT? ›MPT Course Eligibility
Candidates for the MPT course must have a bachelor's degree in physical therapy from a recognized university with a minimum aggregate score of 50%. MPT candidates must have earned a bachelor's degree from an Indian Physiotherapy Association-accredited college or university.