Modern portfolio theory is an investing strategy that minimizes market risk while maximizing returns. It is based on the premise that markets are efficient and utilizes diversification to spread investments across different assets.
Learn the benefits and criticism of this popular investment theory and strategy.
What Is Modern Portfolio Theory (MPT)?
Developed by Nobel Laureate Harry Markowitz, Modern portfolio theory is a widely used investing model designed to help investors minimize market risk while maximizing returns for their portfolio. It is a theory of investing based on the premise that markets are efficient and more reliable than investors.
Investors can use modern portfolio theory to choose the investments in their portfolio. Modern portfolio theory generally advocates a buy-and-hold strategy with occasional rebalancing.
Alternate name: mean-variance analysis
How Modern Portfolio Theory Works
Modern portfolio theory 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. However, 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.
Instead of holding only risky stocks, for example, or only low-return bonds, an investor would buy and hold a mixture of both to ensure the maximum possible return over time.
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 portfolio overall.
Types of 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.
Instead, 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 an efficient portfolio is through a strategic, or passive, approach where you buy and hold combinations of assets and investments that aren't positively correlated, or don't move up and down under the same 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 both 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 class 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 investment selection governed by MPT might be a portfolio of mutual funds containing:
- 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 periodically to rebalance your portfolio, or bring it back to its original asset allocation, to avoid overweighting certain assets and keep your holdings in sync with your investment goals.
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.
This approach might create a two-fund portfolio divided 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.
Pros and Cons of Modern Portfolio Theory (MPT)
No timing the market
Suitable for average invstor
Decreases risk in investing
Not based on modern data
- No timing the market: Most investors want to maximize their returns for minimal risk but don't have the time, knowledge, or emotional distance to be successful at market timing.
- Suitable for average investor: An average investor can benefit from applying MPT or incorporating its key ideas to achieve a balanced portfolio that is set up for long-term growth.
- Decreases risk in investing: Spreading your investments across assets that aren't positively correlated protects you from changes in the market.
- Not based on modern data: The concepts of risk, reward, and correlation that underlie MPT are derived from historical data. This data may not be applicable to new circumstances in the market.
- Standardized assumptions: MPT functions bases on a standardized set of assumptions about market behavior. These assumptions may not bear out in a constantly changing financial climate.
Alternatives to Modern Portfolio Theory
Some investors will feel that understanding of behavior and price volatility in the market will allow them to make more timely investment decisions. If you are uncomfortable with the buy-and-hold nature of modern portfolio theory, a tactical asset allocation approach may be an option.
With tactical asset allocation, you can still incorporate the three primary asset classes (stocks, bonds, and cash) into your portfolio. Unlike investors who use MPT, however, you would then actively balance and adjust the weights (percentages) of the assets using technical and fundamental analysis to maximize portfolio returns and minimize risk compared to a benchmark.
Other investors may find that a combination of the two approaches is the best strategy. For example, you may generally buy and hold assets according to MPT, but still take advantage of changes in the market, such as buying more stocks during a recession when they are lower in price. You would then hold these assets for a long time to allow them to return to their pre-recession levels and increase the value of your portfolio.
- Modern portfolio theory is an investing strategy that focuses on minimizing market risk while maximizing returns.
- It was developed by Nobel Laureate Harry Markowitz and utilizes diversification to spread investments across different asset classes, creating higher returns at lower levels of risk.
- It generally advocates a buy-and-hold strategy with occasional rebalancing.
- Critics say it is based on historical assumptions that may not always prove correct in modern markets.
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.