Modern Portfolio Theory: MPT Definition and Investing Strategies

Definition, Investing Strategies, Example and Criticisms of MPT

Investing-theory-graph.jpg
Learn modern portfolio theory and how it can help you invest. Getty Images

Even if you find that you don't agree with the idea of modern portfolio theory, learning the basics of MPT can help you become a better investor.

Modern Portfolio Theory: MPT Definition

Modern Portfolio Theory (MPT) is an investing model where the investor attempts to take minimal level of market risk to capture maximum-level returns for a given portfolio of investments. However, although widely used within the financial industry, there are recent criticisms and variations of style to consider before applying MPT to your own investment portfolio and strategy.

Investing Strategies and Example of MPT

At the core of investment philosophy, every investor would like to achieve the highest possible long-term returns possible without taking extreme levels of short-term market risk. But how can this be done? The short answer is diversification. According to MPT, an investor can hold a particular asset type, mutual fund, or security that is high in risk individually but, when combined with several other asset types or investments, the whole portfolio can be balanced in such a way that its risk is lower than some of the underlying assets or investments.

For example, as an asset class, stocks are generally higher in market risk than bonds. However, a portfolio consisting of stocks and bonds may accomplish a reasonable return for a relatively lower level of risk. On the investment level, foreign stocks (aka international stock) and small-cap stocks are generally higher in risk than large-cap stocks but all three can combine for above average returns for average risk, as compared to a benchmark such as the S&P 500, over long periods of time.

A typical example might be this moderate portfolio of mutual funds types:

40% Large-cap stock (Index)
10% Small-cap stock
15% Foreign Stock
30% Intermediate-term Bond
05% Cash/Money Market

Many investors and investment advisers employ a type of nuanced MPT investment style called Tactical Asset Allocation, which applies elements of Modern Portfolio Theory.

With Tactical Asset Allocation, the investor can use the three primary asset classes (stocks, bonds and cash) and actively balance and adjust the weights (percentages) of the portfolio with the goal of maximizing portfolio returns and minimizing risk compared to a benchmark, such as an index.

Criticism of MPT

Some critics of MPT include investors who prefer technical analysis and the reliance on trends and psychology rather than the simple buy-and-hold nature of MPT. An argument can always be made that an understanding of behavior and price volatility in the markets, and hence the ability to make timely investment decisions, can serve the investor better than a balanced asset allocation approach. However, many investors fail at market timing and most do not have the time, knowledge, or psychological disposition to be successful at it. Therefore most investors can benefit from following MPT, or at least incorporating its key ideas into a tactical asset allocation approach.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.