An introduction to Modern Portfolio Theory (MPT)

QuietGrowth - An introduction to Modern Portfolio Theory (MPT)

Modern Portfolio Theory (MPT) is an investment theory developed by Harry Markowitz in 1952. He was later awarded a Nobel Prize in Economics for his work in this area. The theory attempts to maximise portfolio expected return for a given amount of portfolio risk, or equivalently minimise risk for a given level of expected return. The investor can attempt this by carefully choosing the proportions of various assets.

The key concepts of Modern Portfolio Theory include:

  • Diversification: At the heart of MPT lies the concept of diversification. This refers to spreading investments across various assets or asset classes to reduce risk. Diversification can help investors to limit exposure to any single asset or risk.
  • Efficient frontier: This is a graphical representation of all possible combinations of assets that maximises expected return for a given level of risk. This is a curve that plots the optimal portfolios that offer the highest expected return for a defined level of risk. The efficient frontier enables investors to understand the trade-off between risk and return and identify which portfolios maximise expected return for a given risk level.
  • Risk and return: MPT assumes that investors are risk-averse, meaning they prefer a less risky portfolio to a more risky one for a given level of return. This implies that if an investor takes on more risk, they require more return.
  • Correlation: This statistical measure indicates how two securities move in relation to each other. Assets can be positively correlated, negatively correlated, or uncorrelated. MPT suggests including negatively correlated investments in a portfolio to reduce overall portfolio risk.
  • Capital Asset Pricing Model (CAPM): Building upon MPT, this model defines the relationship between expected return and risk for a security. It uses the concept of systematic risk, also known as market risk, to measure the risk associated with a specific investment.
  • Beta: This is a measure of a security’s risk in relation to the market. A beta of less than 1 indicates the security is theoretically less volatile than the market, whereas a beta greater than 1 indicates higher volatility than the market.
  • Expected return: This is the amount of profit or loss an investor anticipates on an investment.

By considering these and other factors, MPT offers a mathematical framework for designing a portfolio of assets that maximises expected return for a given level of risk.

History of Modern Portfolio Theory

Modern Portfolio Theory (MPT) was developed by Harry Markowitz and published in his paper “Portfolio Selection” in 1952. Markowitz was a young graduate student at the University of Chicago at the time, and his research fundamentally transformed how investors think about risk and return.

Before Markowitz, investment analysis primarily focused on assessing the risks and returns of individual securities. The prevailing wisdom was to identify and invest in the securities that were expected to have the highest returns or seemed the most undervalued, often ignoring the broader portfolio context.

Markowitz introduced a more mathematical and systematic approach, arguing that investment risk should be assessed not just on an individual security basis but on how each security contributes to the portfolio’s overall risk and return. He proposed that by combining different types of assets, an investor could optimise her returns based on her risk tolerance.

This was a groundbreaking idea, as it showed that portfolio risk is not simply the weighted average of the individual securities’ risks. Instead, because of the way different securities interact, it’s possible for the total portfolio risk to be less than the sum of its parts. This is particularly the case when the price movements of the securities in the portfolio are not perfectly correlated.

In 1959, Markowitz further expanded on these concepts in his book, “Portfolio Selection: Efficient Diversification of Investments.” This work laid the foundation for the Capital Asset Pricing Model (CAPM), introduced by Sharpe, Lintner, and Mossin, which extended MPT by developing a relationship between risk and expected return.

In 1990, Markowitz, along with Merton Miller and William Sharpe, got the Nobel Prize in Economics for their work on financial economics, with Markowitz specifically recognised for his contributions to portfolio theory. Since then, MPT has become a cornerstone of finance and investment studies and is widely used in investment decision-making.

Applications of Modern Portfolio Theory

MPT’s key concepts of diversification and risk-return optimisation form the bedrock of many investment strategies today. Financial advisers and portfolio managers use MPT to help investors construct portfolios that align with their risk tolerance, investment horizon, and financial goals.

By applying the principles of MPT, investors can create a well-diversified portfolio that minimises risk and maximises potential returns. This could involve spreading investments across different asset classes, such as stocks, bonds, real estate and commodities. In addition, the goal is to include negatively correlated assets – when one asset decreases in value, another might increase, thus reducing the overall portfolio risk.

Moreover, MPT is not limited to individual investors. It is used extensively by mutual funds, hedge funds, and other institutional investors to create various financial products.

Limitations of Modern Portfolio Theory

Some of the limitations or critiques of MPT are:

  • Assumption of investor rationality: MPT assumes that all investors are rational and will always make decisions that maximise their returns relative to risk. However, the field of behavioural finance has provided ample evidence that investors are often influenced by emotional and cognitive biases, leading to irrational decisions.
  • Assumption of uniform market perception: MPT assumes that all investors perceive the market in the same way, have access to the same information and agree on the risks and returns of all investments. However, it is not always true in practice. In reality, information asymmetry and differing perceptions can impact investment decisions.
  • Reliance on historical data: MPT relies heavily on historical data to calculate risk and return, but past performance does not always indicate future results.
  • Constancy of correlation and volatility: The theory assumes that the correlation between asset classes and their individual volatilities remain constant, which can be unrealistic as correlations can and do change over time based on various economic and market conditions.
  • No qualitative approach: MPT is a purely quantitative model and does not consider qualitative factors such as the quality of a company’s management or competitive positioning, which can significantly impact the company’s performance.

Alternatives to Modern Portfolio Theory

Several alternative theories to MPT try to address the criticisms of MPT. They include:

  • Behavioural Portfolio Theory (BPT): BPT challenges the notion of investor rationality. It incorporates insights from behavioural finance, acknowledging that investors often make decisions based on emotions and cognitive biases. BPT aims to create portfolios that not only maximise returns relative to risk but also consider investor psychology.
  • Post-Modern Portfolio Theory (PMPT): PMPT builds on MPT but replaces the standard deviation as a measure of risk with downside risk. Investors care more about downside volatility than overall volatility, as the former can lead to financial loss. PMPT also allows for changing correlations and volatilities, providing a more realistic model of market behaviour.
  • Adaptive Market Hypothesis (AMH): Proposed by MIT professor Andrew Lo, the AMH blends the efficient market hypothesis of MPT with principles from behavioural finance. It suggests that market efficiency is not static but evolves as investors adapt to changing market conditions.
  • Black-Litterman Model: This model, developed by Fischer Black and Robert Litterman, incorporates investor views into the portfolio optimisation process. It addresses the critique that MPT relies solely on historical data. It also allows for more personalised portfolio construction.

Modern Portfolio Theory versus Behavioural Finance

Modern Portfolio Theory (MPT) and behavioural finance represent two influential schools of thought in the finance and investing world. While they both aim to understand and guide investment decisions, they approach the subject from fundamentally different perspectives.

While it may seem that MPT and behavioural finance are at odds with each other, they can be seen as complementary. Recognising the insights from both schools of thought can lead to a more holistic investment strategy. Ultimately, both theories aim to help investors make better decisions and achieve their financial goals.

Relation between MPT and Efficient Market Hypothesis

Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMH) are two related foundational concepts in finance, but they address different aspects of investment theory.

MPT, proposed by Harry Markowitz in the 1950s, focuses on constructing portfolios to maximise expected return for a given level of risk. MPT is more about allocating investments once you have decided the expected returns and risks for different assets.

On the other hand, the Efficient Market Hypothesis, proposed by Eugene Fama in the 1960s, is about how those expected returns are determined. EMH posits that financial markets are efficient, meaning prices fully reflect all available information at any given time. In an efficient market, it’s impossible to consistently achieve higher-than-average returns through trading or market timing because asset prices already incorporate and reflect all relevant information. This implies that the best strategy for most investors is to hold a well-diversified portfolio, which aligns well with the principles of MPT.

In a way, EMH provides a rationale for the assumptions underlying MPT. If markets are efficient, then the return of a portfolio will only depend on the risk that investors are willing to take, as MPT suggests. However, it’s worth noting that both EMH and MPT make certain assumptions about markets and investor behaviour. In reality, markets may not always be fully efficient, and investors may not always behave rationally, so both theories have some limitations.

Related information

Refer to the related knowledge resources:

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