Modern Portfolio Theory - MPT

Loading the player...

What is 'Modern Portfolio Theory - MPT'

Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance.

BREAKING DOWN 'Modern Portfolio Theory - MPT'

A major insight provided by MPT is that an investment's risk and return characteristics should not be viewed alone, but should be evaluated by how the investment affects the overall portfolio's risk and return.

MPT shows that an investor can construct a portfolio of multiple assets that will maximize returns for a given level of risk. Likewise, given a desired level of expected return, an investor can construct a portfolio with the lowest possible risk. Based on statistical measures such as variance and correlation, an individual investment's return is less important than how the investment behaves in the context of the entire portfolio.

Portfolio Risk and Expected Return

MPT makes the assumption that investors are risk-averse, meaning they prefer a less risky portfolio to a riskier one for a given level of return. This implies than an investor will take on more risk only if he or she is expecting more reward.

The expected return of the portfolio is calculated as a weighted sum of the individual assets' returns. If a portfolio contained four equally-weighted assets with expected returns of 4, 6, 10 and 14%, the portfolio's expected return would be:

(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%

The portfolio's risk is a complicated function of the variances of each asset and the correlations of each pair of assets. To calculate the risk of a four-asset portfolio, an investor needs each of the four assets' variances and six correlation values, since there are six possible two-asset combinations with four assets. Because of the asset correlations, the total portfolio risk, or standard deviation, is lower than what would be calculated by a weighted sum.

Efficient Frontier

Every possible combination of assets that exists can be plotted on a graph, with the portfolio's risk on the X-axis and the expected return on the Y-axis. This plot reveals the most desirable portfolios. For example, assume Portfolio A has an expected return of 8.5% and a standard deviation of 8%, and that Portfolio B has an expected return of 8.5% and a standard deviation of 9.5%. Portfolio A would be deemed more "efficient" because it has the same expected return but a lower risk. It is possible to draw an upward sloping hyperbola to connect all of the most efficient portfolios, and this is known as the efficient frontier. Investing in any portfolio not on this curve is not desirable.

Harry Markowitz was awarded a Nobel prize for developing MPT.

RELATED TERMS
  1. Homogeneous Expectations

    An assumption in Markowitz Portfolio Theory that all investors ...
  2. Post-Modern Portfolio Theory - ...

    A portfolio optimization methodology that uses the downside risk ...
  3. Portfolio Variance

    The measurement of how the actual returns of a group of securities ...
  4. Portfolio Return

    The monetary return experienced by a holder of a portfolio. Portfolio ...
  5. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment ...
  6. Harry Markowitz

    A Nobel Memorial Prize winning economist who devised the modern ...
Related Articles
  1. Trading

    Modern Portfolio Theory: Why It's Still Hip

    See why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
  2. Investing

    Understanding Modern Portfolio Theory

    Modern portfolio theory describes ways of diversifying assets in a portfolio in order to maximize the expected return given the owner’s risk tolerance.
  3. Managing Wealth

    Manage Investments And Modern Portfolio Theory

    Modern Portfolio Theory suggests a static allocation which could be detrimental in declining markets, making it necessary for continuous risk assessment. Downside risk protection may not be the ...
  4. Trading

    How to Create a Risk Parity Portfolio

    Learn about how risk parity uses leverage to create equal exposure to risk among different asset classes in portfolio construction.
  5. Managing Wealth

    The Workings Of Equity Portfolio Management

    Achieve analytical efficiency by applying your evaluation to a key set of stocks.
  6. Managing Wealth

    Using Normal Distribution Formula To Optimize Your Portfolio

    Normal or bell curve distribution can be used in portfolio theory to help portfolio managers maximize return and minimize risk.
  7. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  8. Investing

    Find The Highest Returns With The Sharpe Ratio

    Learn how to follow the efficient frontier to increase your chances of successful investing.
  9. Managing Wealth

    Calculating Portfolio Variance

    Portfolio variance is a measure of a portfolio’s volatility, and is a function of two variables.
  10. Investing

    The History Of The Modern Portfolio

    Learn how the writings of John Burr Williams and Harry Markowitz led to the creation of the investment portfolio.
RELATED FAQS
  1. How is portfolio variance reduced in Modern Portfolio Theory?

    Learn about modern portfolio theory, specifically what it asserts about asset allocation and managing portfolio risk through ... Read Answer >>
  2. Why is risk return tradeoff important in designing a portfolio?

    Learn how the risk return tradeoff is used in the construction of portfolios, and how modern portfolio theory seeks to diversify ... Read Answer >>
  3. What are the advantages of portfolio planning with the efficient frontier?

    Learn about modern portfolio theory and the efficient frontier. Understand the advantages of portfolio planning with the ... Read Answer >>
  4. What types of assets lower portfolio variance?

    Learn what type of assets reduce portfolio variance and how modern portfolio theory uses correlation coefficients. Read Answer >>
  5. Where did Modern Portfolio Theory (MPT) come from?

    Learn about modern portfolio theory, or MPT, and its origins. MPT has become a standard paradigm through which investors ... Read Answer >>
  6. What level of correlation among investments will guarantee market returns but have ...

    Learn how modern portfolio theory uses correlation to determine the efficient frontier for which assets to include in a portfolio ... Read Answer >>
Hot Definitions
  1. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  2. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  3. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  4. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  5. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  6. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
Trading Center