Anyone who wants to can now trade stocks on the stock market. Unlike the old way of trading, you can now trade with just a few taps on your phone. But is that it? Is having a stable internet connection and a phone all you need to trade stocks? No. It means you have to come up with smart trading plans. Modern Portfolio Theory is one such trading strategy that we should talk about.
In short, modern portfolio theory says that the best way to make money is to have a diverse investment portfolio. To put the theory into practice, you need to know it inside and out. Let's get into the details.
Understanding Modern Portfolio Theory in Detail
Modern Portfolio Theory, or MPT, is a practical method for selecting investments to manage risk. The simple idea behind it is that you can have high-risk, high-return assets or low-risk, low-return assets. A sensible portfolio often involves a mix of both.
The theory was first introduced in a 1952 paper by economist Harry Markowitz. He argued that investors could construct an "efficient" portfolio by combining assets based on their individual risk and return characteristics, rather than choosing each one in isolation.
The key takeaway from MPT is this: don't just look at an investment on its own. Instead, consider how it behaves in relation to everything else in your portfolio. That's the real core of the idea.
Types of Modern Portfolio Theory
MPT is a single theory, but its framework helps investors choose portfolios based on their goals. These aren't "types" but theory-based results.
Minimum Variance Portfolio: This portfolio minimises risk for a given return. It’s designed for an investor whose primary goal is capital preservation.
Ideal Risky Portfolio: This portfolio has the highest Sharpe ratio and best risk-to-reward ratio. Best risky asset mix on the efficient frontier.
Efficient Frontier Portfolios: This isn't just one portfolio; it's a whole bunch of them. The efficient frontier shows all portfolios with the best expected return for each risk level.
Advantages and Disadvantages of the Modern Portfolio Theory in Finance
MPT, like any other financial theory, has both good and bad points. Before using its ideas in your own investment philosophy, you need to understand both sides. Here is a fair look at the good and bad sides.
Advantages
| Disadvantages
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Encourages diversification: The fundamental concept is to distribute investments across diverse assets to minimise risk, which is a wise and widely acknowledged method.
| It Uses Data from the Past: The idea tries to forecast future risk and correlation by looking at how things have gone in the past. This isn't always a smart technique to figure out what's going to happen.
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Makes an "Efficient" Framework: It provides you a technique to design a portfolio that tries for the highest return for a particular degree of risk.
| Assumes Investor Rationality: MPT is founded on the notion that all investors are rational. It doesn't think about choices made because of fear and greed.
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Helps Control Volatility: By combining assets that don't move in the same direction, you can help even out the price swings in your portfolio as a whole.
| Ignores Real-World Costs: The basic model doesn't include key charges like taxes, broking fees, or other transaction fees that influence real returns.
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Modern Portfolio Theory Formula in Finance
The main idea behind Modern Portfolio Theory is maths. You don't have to be a math whiz to understand it, but understanding the basic sections can help you comprehend how they all fit together.
The first thing you need to do is find out how much money you can anticipate making from a portfolio. This is essentially the average of the predicted returns on all the assets you possess, with the amount you own of each taken into account.
Portfolio risk is the more difficult component. MPT uses variance or standard deviation to figure this out. The portfolio's risk is not merely the average risk of its assets, which is quite important. Another component has a big effect on it.
That factor is correlation. This measures how two assets move in relation to each other. MPT's real insight is that by combining assets with low or negative correlation, you can lower the portfolio's overall risk.
These concepts are visualised in the Efficient Frontier. It's a graph that plots all the optimal portfolios, each offering the highest possible return for its level of risk. It’s the visual output of the theory.
Finally, the Capital Allocation Line helps identify the single best portfolio on that frontier by introducing a risk-free asset. It shows the best possible risk-reward trade-off available to an investor.
Criticism of the Modern Portfolio Theory (MPT)
MPT is an important part of finance, but not everyone agrees with it. Over the years, a lot of people have said that it doesn't always work in the real world because its main ideas aren't always true.
The most common criticism of it is that it uses past data to predict the future. The theory uses past variance and correlation as inputs, but these relationships can change a lot and without warning as markets change.
Another major point of contention is its definition of risk. MPT uses variance, which treats upside volatility (gains) and downside volatility (losses) as equally bad. Most investors, however, are primarily concerned with the risk of losing money.
The theory also assumes that investment returns follow a normal distribution, or a neat bell curve. In reality, markets can experience extreme, unpredictable events—often called "black swan" events—far more frequently than this model suggests.
Finally, MPT is built on the premise of a "rational investor" who always makes logical, unemotional decisions. As the field of behavioural finance has shown, this is rarely the case in practice.
How to Use Modern Portfolio Theory in Finance
Modern portfolio theory is widely applied in the field of finance especially when it comes to assessing risk to reward factors of any investment.
To use modern portfolio theory in finance, a general rule that is followed by experts is to evaluate every investment with a perspective of return and risk ratio. Any investment that comes with high returns will have high risk and the general assumption is that investors are likely to choose investments that has low risk and low returns.
Limitations of Modern Portfolio Theory
Modern portfolio theory comes with certain limitations as well that must be taken into consideration before applying it practically.
Firstly, the theory speaks about a rational method of trading and investing that is not practical. Whether they are a beginner or an expert, it is common for them to indulge in some degree of emotional trading that impacts their portfolio. While it is important to reduce emotional decisions, they cannot be eliminated completely while preparing a portfolio graph.
Additionally, the reliance on variance also limits the theory’s approach. According to the theory, any set of data showing the same level of variance will have the same level of appeal in the market as well. However, it fails to include factors that result in the same level of variance.
Lastly, know that a portfolio is not limited to assets; rather, it includes the broking cost, platform charges, maintenance fees, etc. Modern portfolio theory does not take any of these things into account when it looks at portfolios.
MPT vs. Post-Modern Portfolio Theory
Some of the problems with MPT were fixed by the creation of Post-Modern Portfolio Theory (PMPT). The theory in question is not a replacement; instead, it signifies an evolution designed to tackle particular challenges inherent in the original theory.
The main difference is how risk is defined. MPT looks at all kinds of volatility, but PMPT only looks at downside deviation. It only looks at the "bad" volatility that causes returns to drop below a certain minimum level, which is more in line with how investors really see risk.
How Do Regular Investors Apply Modern Portfolio Theory?
You might not be doing complicated maths, but you are probably already using the main idea behind MPT. According to MPT, you should invest in stocks, bonds, gold, and real estate.
Instead of buying one company's stock, you use the theory to manage risk by investing in a mutual fund or ETF. It's the age-old advice not to put all your eggs in one basket.
Conclusion
Modern Portfolio Theory really changed how people invest. It was the first to give a clear, mathematical explanation of the benefits of diversification, and its main idea is still as true today as it was in 1952.
Its main idea is still true, even though it has some flaws and has been improved by newer theories. A basic rule for any smart investor is that you should build a portfolio of different types of assets to spread out your risk.
