Finance

Modern portfolio theory

Modern Portfolio Theory

Modern portfolio theory is an investment theory. It allows the investor to assemble an asset portfolio that will maximize the return for a particular level of risk. The theory assumes investors will prefer less risky portfolios. Modern portfolio theory (MPT) can also be used to construct a portfolio that will minimize ↓ risk for a given level of expected return. Due to the abundance of market data, market risk has attracted significant interest since the 1950s.

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What is Modern Portfolio Theory?

The criterion for a good market model is that it must have acceptable explanatory power without being unnecessarily complex. Investors who are concerned with downside ↓ risk more than variance might prefer PMPT (Post Modern Portfolio Theory) to MPT (Modern Portfolio Theory). The expected return of modern portfolio theory can be calculated as a weighted sum of individual asset returns.

There are some assumptions to the theory and they are as under.

  • The returns are normally distributed. Investors only consider the mean and the variance of return distributions (with a skewness = 0 and kurtosis = 3).
  • The theory assumes that the investors are rational as well as risk-averse.
  • There is perfect competition in the capital market.

For example: suppose a portfolio contained 4 equally weighted assets with the expected return of 5, 6, 12, and 15%. Then the portfolio’s expected return would be calculated as follows

Expected return = (5% x 25%) + (6% x 25%) + (12% x 25%) + (15% x 25%) = 9.5%

How does it work?

Modern portfolio theory has a market impact on how investors perceive risk, portfolio management, and return. Portfolio diversification reduces investment risk according to the theory. Losses in any individual stocks are not material enough to damage performance due to diversification and the success and prevalence of passive investing.

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Importance of MPT:

For investors who try to build diversified portfolios, this theory is very helpful. The growth of Exchange-traded funds (ETF) gave investors easy access to different asset classes which made Modern Portfolio Theory (MPT) more relevant. This theory is also used by stock investors to reduce risk by investing a small portion of their portfolio in government ETF. As government bonds have a negative correlation with stocks the variance of the portfolio will be significantly lower. Adding a small investment in Treasuries to a stock portfolio will not have a large impact on expected returns because of this loss reducing the effect.

Criticism:

MPT evaluates portfolios based on variance rather than downside risk. This is the most serious criticism. Any two portfolios holding the same level of variance and returns are considered equally desirable under modern portfolio theory. Post-Modern Portfolio Theory (PMPT) helps to improve modern portfolio theory. It helps in minimizing downside risk and not variance. If a portfolio may have variance due to small losses and the other portfolio may have a variance due to rare speculator declines then most of the investors would prefer frequent small losses ad it would be easier to endure.

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Bottom Line:

The people who beat the market are those who take on the above-average risk because the market is hard to beat and this is the core of MPT. Also, these risk-takers will get their recompense when markets turn down. But again, portfolio theory is just a theory and so at the end of the day, a portfolio’s success will only depend on the investor’s skills and the time that they devote to it. So it is better to invest in a small number and wait for the market to turn in your favor.

Author Saachi Lodha

About the Author – A passionate professional with knowledge of Accounting and Finance and currently exploring Financial Risk Management (FRM) to gain knowledge and exposure. As a part of the FRM course also writing blogs to explore the field more and deep dive into the content.

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