What Is Modern Portfolio Theory (MPT)?

Overview, Investing Strategies, and Interpretations of MPT

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Developed by Nobel Laureate Harry Markowitz, Modern Portfolio Theory (MPT) is a widely used investing model that enables risk-averse investors to minimize market risk and at the same time maximize returns for a given portfolio of investments.

Investors can use MPT to choose the investments that they hold in an investment portfolio. However, there are criticisms and variations in investing style to consider before applying MPT to your own investment strategy. Learning about what MPT can do for your portfolio can make you a better investor.

How Modern Portfolio Theory Works

MPT assumes that every investor wants to achieve the highest possible long-term returns without taking extreme levels of short-term market risk. However, risk and reward are positively correlated in investing, so if you opt for low-risk investments, such as bonds or cash, you can expect lower returns. Conversely, you'll need to invest in riskier, more volatile investments like stocks to receive higher returns. But depending on your comfort level with risk, you may not be willing to take the gamble and put your money into those investments.

The way to overcome this dilemma, MPT proposes, is through diversification, which refers to the spread of money across different asset classes and investments. According to MPT, an investor can hold a particular asset type or investment that is high in risk individually, but, when combined with several others of different types, the whole portfolio can be balanced in such a way that its risk is lower than the individual risk of underlying assets or investments.

A simple way to remember the MPT philosophy is that "the whole is greater than the sum of its parts." Risky individual investments do not necessarily make for a risky overall portfolio.

Modern Portfolio Theory Investing Strategies

When choosing investments in accordance with MPT, your goal shouldn't be to accept the highest risk to extract the highest returns. Rather, your portfolio should be on what Markowitz called the "efficient frontier," meaning it should balance risk and reward in such a way that you get the highest return at an acceptable level of risk. There are several ways to accomplish this goal.

Strategic Asset Allocation

The simplest way to create a portfolio on the efficient frontier is through a strategic, or passive, approach where you buy and hold combinations of assets and investments that aren't correlated, or don't move up and down in price in perfect synchrony under different market conditions. You include these investments in your portfolio in fixed percentages.

For example, as an asset class, stocks are generally higher in market risk than bonds. But a portfolio consisting of stocks and bonds may accomplish a reasonable return for a relatively lower level of risk. Moreover, since stocks and bonds are negatively correlated (as stocks go up in price, bonds tend to go down in price), this MPT strategy further minimizes substantial losses in your overall portfolio value when one asset declines.

Similarly, on the investment level, foreign stocks (aka international stock) and small-cap stocks are generally higher in risk than large-cap stocks. Modern portfolio theory allows you to combine all three to potentially achieve above-average returns compared to a benchmark such as the S&P 500, all for an average level of risk.

An example of investment selection governed by MPT might be this portfolio of mutual funds:

40% Large-cap stock (Index)
10% Small-cap stock
15% Foreign stock
30% Intermediate-term bond
5% Cash/Money market

Even with a strategic asset allocation approach, it's important to rebalance your portfolio over time, or bring it back to its original asset allocation, to avoid overweighting certain assets and keep your holdings in sync with your investment goals.

Two-Fund Theorem

You don't need a complex portfolio comprising several investments to comply with MPT. Modern portfolio theory stipulates that you can achieve a portfolio on the efficient frontier with only two mutual funds. This approach allows you to avoid picking any individual stocks.

An example of this approach might be a two-fund portfolio that divides assets equally between stocks and bonds:

50% Large-cap, mid-cap, and small-cap stock
50% Corporate bonds and short-term, medium-term, and intermediate-term government bonds

Between 1970 and 2003, a portfolio equally split between stocks and bonds would have produced similar returns at a lower level of volatility and greater diversification than either asset class alone.

Tactical Asset Allocation

More proactive investors and investment advisors may prefer to employ a more nuanced approach to the MPT investment style known as tactical asset allocation. With this investment approach, an investor can still incorporate the three primary asset classes (stocks, bonds, and cash) into their portfolio, but should actively balance and adjust the weights (percentages) of the assets using technical analysis and trends and psychology to maximize portfolio returns and minimize risk compared to a benchmark.

Criticism of Modern Portfolio Theory

MPT critics cite that the concepts of risk, reward, and correlation that underlie the approach are derived from predictions about financial markets that are based on historical data. They suspect that its use as an investment selection tool is limited because such assumptions may not bear out in a constantly changing financial climate.

The argument can always be made that an understanding of behavior and price volatility in the market, and hence, the ability to make timely investment decisions, can serve the investor better than the buy-and-hold nature of MPT. A tactical asset allocation approach may be an option for investors who hold this view.

Bottom Line

Most investors want to maximize their returns for minimal risk but fail at market timing and don't have the time or knowledge to be successful at it. Therefore, the average investor can benefit from applying MPT, or at least incorporating its key ideas into a tactical asset allocation approach, to achieve a balanced portfolio that is set up for long-term growth.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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