Modern portfolio theory (MPT) is an investing strategy that seeks to optimize the risk-return tradeoff in a diversified portfolio. MPT is based on the premise that markets are efficient; it uses diversification to spread investments across assets.
Learn the pros and cons of this popular theory.
Definition and Examples of MPT
Developed by Nobel Laureate Harry Markowitz, MPT is a widely used model. It's meant to help investors minimize market risk. At the same time, it can maximize their returns. MPT is a theory based on the premise that markets are efficient and more reliable than investors.
- Alternate name: Mean-variance analysis
- Acronym: MPT
You can use MPT to choose the investments in your portfolio. MPT most often promotes a buy-and-hold strategy with occasional rebalancing.
How MPT Works
MPT assumes that every investor wants to achieve the highest possible long-term returns without taking extreme levels of short-term market risk. But risk and reward are positively correlated in investing; if you opt for low-risk investments, such as bonds or cash, you can expect lower returns.
You'll need to invest in investments with more risk, like stocks, to receive higher returns. You may not be willing to take the gamble and put your money into those investments. It depends on your comfort level with risk.
The way to overcome this, MPT says, is through diversification. This refers to the spread of money across different asset classes and investments.
MPT says you can hold a certain asset type or investment that is high in risk. But when you combine it with others of different types, the whole portfolio can be balanced. Then its risk is lower than the individual risk of underlying assets or investments.
For instance, you wouldn't hold only risky stocks or only low-return bonds. Instead, you would buy and hold a mixture of both to ensure the largest possible return over time.
A simple way to remember MPT is that "the whole is greater than the sum of its parts." Risky individual investments do not have to make for a risky portfolio overall.
Types of MPT Strategies
When choosing investments in 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." This means it should balance risk and reward in such a way that you get the highest return at an acceptable level of risk.
There are a few ways to achieve this goal.
Strategic Asset Allocation
The simplest way to create an efficient portfolio is through a strategic, or passive approach. This is where you buy and hold combinations of assets and investments that aren't positively correlated. In other words, they don't move up and down under the same market conditions. You include these in your portfolio in fixed percentages.
For instance, as an asset class, stocks are often higher in market risk than bonds. But a portfolio consisting of both stocks and bonds may achieve a reasonable return for a relatively lower level of risk.
Stocks and bonds are negatively correlated. As stocks go up in price, bonds tend to go down in price. MPT strategy further minimizes substantial losses in your overall portfolio value when one asset class declines.
On the investment level, foreign stocks and small-cap stocks are often higher in risk than large-cap stocks. MPT allows you to combine all three. You can 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. This helps you avoid overweighting certain assets and keep your holdings in sync with your investment goals.
You don't need a complex portfolio made up of many investments to comply with MPT. The theory states that you can achieve an efficient portfolio 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
Let's say you had a portfolio equally split between stocks and bonds. Between 1970 and 2003, it would have produced similar returns at a lower level of volatility and greater diversification than either asset class alone.
Pros and Cons of 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 higher returns for lower risk. But many don't have the time, knowledge, or emotional distance to find success with market timing.
- Suitable for average investor: Anyone can benefit from MPT or using its key ideas to achieve a balanced portfolio that is set up for long-term growth.
- Decreases risk in investing: It's a good idea to spread your investments across assets that aren't positively correlated. This 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 may not bear out in a constantly changing financial climate.
Alternatives to MPT
You may feel that knowledge of behavior and price volatility in the market will allow you to make more timely investment decisions. If you are uncomfortable with the buy-and-hold nature of MPT, 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. But unlike investors who use MPT, you would then actively balance and adjust the weights (percentages) of the assets. You would do this by using technical and fundamental analysis to maximize portfolio returns and minimize risk compared to a benchmark.
You may find that a combination of the two approaches is the best strategy. For instance, you may often buy and hold assets according to MPT. But you still might take advantage of changes in the market. Perhaps you buy more stocks during a recession when they are lower in price. You would then hold these assets for a long time; this allows them to return to their pre-recession levels and increases the value of your portfolio.
You also may form opinions about some sectors in the economy, for instance, the technology or travel & hospitality industries, and select your favorites stocks in them for a tactical investing layer added on top of a passive long-term MPT strategy.
- Modern portfolio theory is an investing strategy. It focuses on minimizing market risk while maximizing returns.
- MPT uses diversification to spread investments across different asset classes. This creates 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.