Modern portfolio theory, a great ally for your investments

Modern portfolio theory (MPT) is a practical method for selecting investments to maximize their overall return within an acceptable level of risk. Modern portfolio theory holds that the risk and return characteristics of a given investment should not be considered in isolation, but rather should be evaluated in terms of how they affect the risk and return of the overall portfolio. We are going to review what modern portfolio theory is based on and its main benefits and disadvantages.

What is modern portfolio theory

Modern portfolio theory (MPT) is a practical method for selecting investments to maximize their overall return within an acceptable level of risk. This mathematical framework is used to construct an investment portfolio that maximizes the amount of expected return for the given collective risk level. The American economist Harry Markowitz 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, high return or low risk, low return. Markowitz argued that investors could obtain the best results by choosing an optimal combination of the two, based on an evaluation of their individual risk tolerance.

What is modern portfolio theory for?

Modern portfolio theory holds that the risk and return characteristics of a given investment should not be considered in isolation, but rather should be evaluated in terms of how they affect the risk and return of the overall portfolio. That is, an investor can build a multi-asset portfolio that results in higher returns without a higher level of risk. Alternatively, starting from a desired level of expected return, the investor can construct a portfolio with the lowest possible risk that is capable of producing that return. Based on statistical measures such as variance and correlation, the return on a single investment is less important than its impact on the entire portfolio.

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Explanation of modern portfolio theory. Source: WallStreetMojo.

Example of using modern portfolio theory

Modern portfolio theory allows investors to build more efficient portfolios. All possible combinations of assets can be represented 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. This chart 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%. Suppose another 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 lower risk. It is possible to draw an ascending curve that unites all the most efficient portfolios. This curve is called the efficient frontier. Investing in a below-the-curve portfolio is undesirable because it does not maximize returns for a given level of risk.

Benefits of using modern portfolio theory

The TPM is a useful tool for investors trying to create diversified portfolios. In fact, the growth of exchange-traded funds (ETFs) has made 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 in government debt ETFs. The portfolio variance will be significantly lower because government bonds have a negative correlation with stocks. Adding a small investment in Treasury bonds to a stock portfolio will not have a large impact on expected returns due to this loss mitigation effect.

Disadvantages of using modern portfolio theory

Perhaps the most serious criticism of the MPT is that it evaluates portfolios based on variance rather than downside risk. That is, two portfolios that have the same level of variance and profitability are considered equally desirable according to modern portfolio theory. A portfolio can have that variance due to frequent small losses. Another might have that variance due to rare but spectacular declines. Most investors would prefer frequent small losses, which would be easier to bear. Postmodern portfolio theory (PMPT) attempts to improve upon modern portfolio theory by minimizing downside risk rather than variance.


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