What is Modern Portfolio Theory? - Advantages and Disadvantages

Last Updated July 14th 2021
7 Min Read

All of you would know that portfolio management is essential for minimising risks and maximising ROI. A portfolio is a collection of financial investments such as stocks, bonds, commodities, cash, closed-end funds, and exchange-traded funds (ETFs) among others. It is essential to maintain a portfolio if you wish to track and manage your finances better. Although the general belief is that stocks, bonds, and cash make up the core of a portfolio, it is not always true. There is no rule as such. A portfolio can include a wide range of assets such as real estate, art, and private investments, apart from the ones mentioned above.

What Is Modern Portfolio Theory (MPT)?

That brings us to the question – what is Modern Portfolio Theory (MPT)? Well, in simple words, it is a theory about how risk-averse investors can create portfolios to maximise expected returns based on a particular level of market risk. Harry Markowitz was the pioneer of this theory. He proposed the idea in the paper named Portfolio Selection, which was published in the Journal of Finance in 1952. Later, he was awarded a Nobel Prize for his work on modern portfolio theory.

Key Points:

  • Modern portfolio theory talks about how risk-averse investors can create portfolios to maximise their expected return on a given level of market risk.
  • MPT is also useful in constructing a portfolio that minimises risk for a given level of expected return.
  • Modern portfolio theory is especially useful for investors trying to create efficient portfolios using ETFs.
  • Investors concerned with downside risk than the variance might prefer Post-Modern Portfolio Theory (PMPT) to MPT.

Modern Portfolio Theory (MPT)

Let us now look into MPT in detail. As mentioned elsewhere, MPT was introduced by Harry Markowitz in 1952. It is a portfolio creation theory that establishes the minimum level of risk for an expected return. The theory assumes that investors will prefer a portfolio with a lower risk level over a portfolio with a higher risk level for the same level of return. The core element of modern portfolio theory is how individual confidence affects the risk and return profile of a portfolio.

So, the MPT says that the traits determining an investment's risk and return shouldn’t be viewed in isolation. Instead, it should also be evaluated by analyzing how the investment affects the overall portfolio's risk and return. MPT illustrates that it is possible to create a portfolio of multiple assets to maximise returns for a given level of risk.

Similarly, if you have an idea of the desired level of expected return, you can construct a portfolio with the lowest possible risk. Depending on statistical measures such as variance and correlation, the performance of an individual investment would be less important compared to its impact on the entire portfolio.

Furthermore, the inherent assumption in MPT is that the investors are risk-averse. It assumes they prefer a low-risk portfolio to a risky one if the level of return is the same. Risk aversion infers that most people should invest in multiple asset classes for greater practicality.

For calculation, the expected return of the portfolio is calculated as a weighted sum of the returns of individual assets in the portfolio. So, if your portfolio contains four equally weighted assets with an expected return of 4, 6, 10, and 12%, the expected return of the portfolio would be calculated as:

(4% x 25%) + (6% x 25%) + (10% x 25%) + (12% x 25%) = 8%

As you can see the portfolio risk calculation is a complicated function comprising the variances of every asset and the correlations between each pair of assets. To determine the risk of a four-asset portfolio, you’ll need the variances and six correlation values of each of these assets, as there would be six possible two-asset combinations. And because of the asset correlations, the overall portfolio risk or standard deviation, will be lower than what would be if you calculated by a weighted sum.

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Advantages of MPT

There are several benefits to MPT. For instance, it can be used as a tool to diversify portfolios. You can reduce the variance by integrating a diverse set of assets into a portfolio. Another benefit of MPT is that it can be used to reduce volatility. You can introduce assets that have a negative correlation into an existing portfolio. A good example of this could be U.S. treasuries and small-cap stocks. By using MPT your portfolio can realise stronger returns instead of exclusively holding on to just one type of asset within a portfolio. As you can see, MPT can be effectively used to create the most efficient portfolio possible.

Let’s take a closer look at the various advantages enjoyed by MPT.

 Diversification tool - MPT is an extremely useful tool if you are looking to build diversified portfolios. The growth of exchange-traded funds (ETFs) has made MPT more relevant as it has given the investors easier access to different asset classes. Those who invest in stocks can use MPT to lower the risk by placing a tiny portion of their portfolios in government bond ETFs. The portfolio variance will be significantly lower in this case as government bonds have a negative correlation with stocks. As such, adding a small investment in treasuries to your stock portfolio will not have a great impact on your expected returns because of the loss-reducing effect.

✅ Manage volatility - MPT can be effectively used to reduce the volatility of a U.S. Treasury portfolio by putting a small percentage, say 10%, in a small-cap value index fund or ETF. Even though the small-cap value stocks carry a higher risk than the Treasuries on their own, they are likely to perform well during periods of high inflation, where bonds do poorly. As a result, the overall volatility of your portfolio will be lower than a portfolio made up of entirely government bonds. Moreover, the expected returns are higher.

✅ Increased efficiency – MPT allows you to create more efficient portfolios. You can plot every possible asset combination that can be plotted on a graph, with the X-axis showing portfolio risk and the Y-axis showing expected return. This plotting will help you spot the most desirable portfolios. For instance, Portfolio A has an expected return of 9.5% with a standard deviation of 8% and Portfolio B has an expected return of 10.5% and a standard deviation of 9.5%. In such a scenario, Portfolio A would be considered more efficient as it has the same expected return at lower risk.

You can draw an upward sloping curve connection to all your most efficient portfolios. This curve, known as the efficient frontier, will help you analyze things better. If a portfolio falls underneath the curve, it is not wise to invest in it because it will not give you maximum returns for the given risk levels. Most portfolios on the efficient frontier include ETFs from more asset classes than one.

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Disadvantages of Modern Portfolio Theory

As in the case of any other theory, MPT also has its disadvantages and share of criticisms. Let’s see what the downsides are if you use MPT.

 Variance-based – The most serious criticism of modern portfolio theory is that it assesses portfolios based on variance and not the downside risks. As a result, two portfolios with the same level of variance and returns are usually considered equally desirable under the MPT. Frequent small losses could be the reason for the variance for one portfolio whereas the other could be showing similar variance because of two or three extraordinary declines. Most investors are likely to prefer frequent small losses as they are easier to endure. To overcome this shortfall of MPT, investors prefer to use the Post-Modern Portfolio Theory (PMPT), which attempts to improve on modern portfolio theory by minimizing downside risk instead of variance.

In this context, it would be pertinent to remember that you can use the efficient frontier to find the set of portfolios that provide the highest level of return for the lowest level of risk. If a portfolio falls to the right of the efficient frontier, which is the cornerstone of modern portfolio theory, it carries a greater risk relative to its potential return. On The Contrary, if a portfolio falls beneath the slope of the efficient frontier, it will give you a lower level of return relative to its potential risk.

Conclusion

It is evident from the advantages discussed above that MPT is an extremely useful tool to minimise risk and earn the best potential returns. It is especially beneficial to those who are averse to taking risks. It is also a great option if you wish to diversify your portfolio without increasing your risk. However, you should not be under the illusion that it is without any faults. A lot depends on your own goal and risk tolerance. You can use the PMPT to overcome the shortcomings of MPT and to earn the best possible returns at the lowest possible risk. When used wisely with the help of an efficient frontier, MPT could be your best bet in many situations.

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