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'

Modern portfolio theory argues 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. Mean-Variance Analysis

    The process of weighing risk against expected return. Mean variance ...
  2. Harry Markowitz

    Harry Markowitz is a Nobel Memorial Prize winning economist who ...
  3. Portfolio Return

    The monetary return experienced by a holder of a portfolio. Portfolio ...
  4. Market Portfolio

    A theoretical bundle of investments that includes every type ...
  5. Mean Return

    1. In securities analysis, it is the expected value, or mean, ...
  6. Risk Management

    Risk management occurs anytime an investor or fund manager analyzes ...
Related Articles
  1. 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 ...
  2. Investing

    Optimize your portfolio using normal distribution

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

    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.
  4. Investing

    How to Create a Low-Risk, High-Return Portfolio

    Modern portfolio theory states diversification will create a lower-risk, higher-return portfolio.
  5. Investing

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  6. Investing

    Diversification: The Oldest Investing Trick in the Book

    Diversification is just as relevant to your investments now as it was 400 years ago.
  7. Investing

    6 Risks Threatening Your Portfolio Today

    Factoring in these risks is crucial when building a portfolio.
  8. Managing Wealth

    Achieve Optimal Asset Allocation

    Minimize risk while maximizing return with the right mix of securities and achieve your optimal asset allocation.
  9. Financial Advisor

    4 Reasons Why Market Correlation Matters

    Learn about how correlation can be used to measure how broader markets move in relation to each other. See how correlation is used to manage risk.
RELATED FAQS
  1. How is correlation used in modern portfolio theory?

    Discover how modern portfolio theory and the efficient frontier use correlation between investment assets to predict an optimal ... Read Answer >>
  2. How do investment advisors calculate how much diversification their portfolios need?

    Learn how modern portfolio theory (MPT) can help determine a diversified mix of assets for inclusion in a portfolio that ... Read Answer >>
  3. Is there a positive correlation between risk and return?

    Learn about the positive correlation between risk and the potential for return, and understand how risk is used to construct ... Read Answer >>
  4. Is variance good or bad for stock investors?

    Learn how high variance stocks are good for some investors and how diversified portfolios can reduce variance without compromising ... Read Answer >>
Hot Definitions
  1. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  2. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  3. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  4. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  5. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  6. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
Trading Center