Modern Portfolio Theory

Do you want to maximize your returns while minimizing risk at the same time?

Of course you do. Who doesn’t?

But that’s a tall order. There’s a lot at stake here, and learning how to minimize risk is quite an undertaking. The world of finance is full of hard-to-understand jargon and technical terms, and getting to grips with all of that isn’t always easy.

Plenty of investors rush in, try to beat the market without doing adequate research, fail, and then wonder where things went wrong. Investing isn’t a game of chance—the market operates in certain ways, as difficult as they are to understand.

However, modern portfolio theory might be just the thing you’re looking for. This Nobel-prize winning theory is the cornerstone upon which plenty of retirement funds are built upon, and it is used by many renowned financial institutions.

Although the applications of MPT are mostly taken care of for you by other institutions, knowing how this theory works is key to understanding the wider financial space. The modern conception of risk and asset allocation is entirely rooted in MPT.

Modern portfolio theory introduced a whole new way of thinking to the world of investing. It isn’t without its flaws, and we’ll cover them too—but MPT is mandatory reading if you want to be a serious investor.

What is Modern Portfolio Theory? 💡

Modern portfolio theory is based upon the work of economist Harry Markowitz. In particular, his 1952 work titled “Portfolio Selection”, published in the Journal of Finance serves as a cornerstone of the theory.

What MPT claims is that it is possible to come up with a portfolio that is optimal—one which provides the greatest return for a specific amount of risk. MPT relies on diversification as a primary means of reducing risk.

Even though you might not have heard of modern portfolio theory before, it forms the basis for the investment decisions of retirement funds and large financial institutions all around the world. It has also been recognized in academic circles—Markowitz received the Nobel Prize for economics in 1990, as well as the John von Neumann Theory prize a year earlier.

Markowitz is still active to this day, as a professor at the University of California in San Diego. And although MPT has seen its fair share of criticism, it is still one of the most influential schools of thought when it comes to investing.

MPT seeks to eliminate risk. More specifically, it seeks to dampen or mitigate the risks that are unique to individual investments—which are called idiosyncratic risks. This is done by diversifying your investments across a wide range of asset classes.

Although applying MPT cannot help with systematic risk—the risk that is inherent to the market at large, a properly diversified portfolio can be less risky than the sum of its parts.

Modern portfolio theory concludes that the market is much more rational than investors, and as such, it promotes a long-term, buy-and-hold strategy with occasional rebalancing.

How MPT Works 🔎

Modern portfolio theory begins with the assumption that investors are, in general, risk-averse. It’s hard to argue with that—none of us actually crave risk, and if we could invest in something that offers great returns and little risk, we’d do it in a heartbeat.

But things don’t work like that. Risk and reward go hand-in-hand, so if you want to acquire large returns, you have to take on risk—this is where MPT comes in.

How does MPT solve this issue? Well, it does so by diversification—spreading out investments over different asset classes. Certain asset classes exhibit correlations—for example, when the market is booming and stocks increase in price, bonds will fall. By making use of these correlations, it is possible to construct a portfolio that will be less risky than all of its parts.

So, what are the steps involved in using MPT? Let’s break it down into the most basic steps:

• Valuing the assets that could be included in the portfolio
• Figuring out an optimal asset allocation
• Optimizing the portfolio—achieving maximum returns for a minimal amount of risk
• Monitoring and rebalancing the portfolio as needed

Correlations 📊

We’ve briefly mentioned correlations above, so let’s take some time to explain them in a bit more detail. Correlations measure how certain securities perform in regard to one another—if they exhibit the same patterns or differing ones.

Correlation is measured by the correlation coefficient, which ranges from -1.0 to +1.0. If two securities have a correlation coefficient of +1, it means that they move in the same way—when one goes down, the other goes down as well—in the same vein, when one goes up, the other goes up too.

A correlation of -1.0 means that the underlying assets move in diametrically opposite directions—when one rises, the other falls. In MPT, investors seek to find securities that have negative correlations—this allows them to hedge their bets and make the biggest use out of diversification.

Calculating Expected Returns ➗

So, now that we have a basic understanding of how MPT works, let’s get down to another important question: How do you calculate expected returns with a portfolio that is constructed utilizing MPT?

It boils down to a simple calculation—you need to figure out the weighted sum of all returns of all the underlying assets in a portfolio. 

Let’s illustrate with an example—a portfolio that has five equally weighted assets. Their returns are 7%, 9%, 12%, 15%, and 17%. To get the portfolio’s expected returns, we do the following: (7% x 20%) + (9% x 20%) + (12% x 20%) + (15% x 20%) + (17% x 20%) = 12.6%

Let’s also use an example where the assets are not equally weighted. Our hypothetical portfolio in this scenario has three assets—weighted at 10%, 20%, and 70% respectively. The first asset has returns of 4%, the second has returns of 6%, and the third has returns of 11%. To get the expected returns, we do the following: (4% x 10%) + (6% x 20%) + (11% x 70%) = 9.3%

Systematic and Unsystematic Risk ⚠️

At its core, MPT is a risk-management strategy. In order to understand it fully, you have to understand risk, and how it relates to the bigger picture.

Modern portfolio theory recognizes two types of risks when it comes to stocks—systematic risk and unsystematic risk.

Systematic risks are risks that are inherent to the broader market. There’s nothing you can do about systematic risk—it includes far-reaching events such as recessions and changes in interest rates. It is also quite hard, if not impossible, to predict such events, as the recent surge in interest rates shows.

You can’t use diversification to reduce systematic risk. However, when it comes to unsystematic risk, the story is a bit different. Unsystematic or specific risk is risk that is inherent to a specific stock. Lower earnings, falling stock prices, and changes in management represent some of the possible avenues of unsystematic risk.

If you diversify your portfolio properly, you will reduce the effect that unsystematic risk has on your overall investments—this, in a nutshell, is the core of modern portfolio theory.

Efficient Frontier Definition 📚

The efficient frontier represents a set of optimal portfolios—those that offer either the highest returns for a specific level of risk or the lowest risk associated with a specific amount of returns.

Put simply, the efficient frontier consists of portfolios that offer the greatest returns for a level of risk. Seeing as how MPT is a mathematical model, the efficient frontier is found on a graph—specifically, a graph where the y axis represents return (usually by way of compound annual growth rate) and the x-axis represents risk (usually by way of annualized standard deviation).

Portfolios that lie on the efficient frontier offer the best returns for a given level of risk. MPT offers a clear-cut way to ascertain whether or not a portfolio is efficient—and it is easy enough to use this theory to improve your own portfolio.

Popular Modern Portfolio Theory Investment Strategies 👇

Modern portfolio theory’s goal of achieving a portfolio that offers maximum returns for a given level of risk can be accomplished in multiple ways. In the next section, we’re going to outline the two most important strategies that are often used when constructing a portfolio according to the precepts of MPT.

Strategic Asset Allocation ✅

The easiest and most straightforward way to construct an optimal portfolio is by utilizing strategic asset allocation. What this means in practice is that you purchase a mix of assets that aren’t positively correlated—they don’t react the same way to market conditions. 

Depending on your desired level of risk, you will construct a portfolio with differing percentages of these assets. Seeing as how your desired level of risk won’t change, these percentages are fixed—so when your portfolio veers off course, you’re going to have to do a bit of rebalancing in order to keep everything in line.

For example, stocks are riskier than bonds, and small-cap and foreign stocks are even riskier. Stocks and bonds are negatively correlated—meaning that when one of them goes up, the other goes down. In fact, we might be seeing the effects of this correlation quite soon, as bond yields might go up.

Purchasing a mix of these assets minimizes losses, no matter the market conditions. A portfolio made in accordance with MPT might contain, for example, 35% large-cap stocks, 15% small-cap stocks, 10% foreign stocks, 30% bonds, and 10% in cash/money-markets. This, of course, is accomplished in the easiest way by purchasing ETFs and mutual funds.

Two Fund Theorem ✌️

The second most popular approach to MPT is the two-fund theorem. This strategy allows you to construct an efficient portfolio using only two mutual funds.

One of the biggest advantages of this approach is simplicity. It spares you from having to pick and research individual stocks. In fact, the entire process of constructing a portfolio using the two-fund theorem is quite straightforward. 

Simply dedicate 50% of your investments to a fund that consists of large-cap, mid-cap, and small-cap stocks, and the other 50% to long-term, medium-term, and short-term government bonds, as well as corporate bonds.

Looking at historical data, such a portfolio would have provided you with similar returns as either asset class by itself, but at a much lower level of risk.

Who Uses Modern Portfolio Theory ❓

Modern portfolio theory has a pretty wide range of uses. Although it is possible for retail investors to make use of this theory, it requires quite a bit of research and some complex mathematics. All in all, it isn’t the most practical (or fun) approach for most individual investors.

However, that doesn’t mean that the benefits of MPT are out of your reach. In fact, it’s pretty easy to reap the benefits of Markowitz’s theory—robo-advisors, ETFs, retirement funds, and a whole variety of other passive funds utilize this theory. In fact, nowadays you’d be hard-pressed to construct a portfolio that doesn’t utilize MPT at some level.

So, what’s the easiest way to incorporate MPT into your investment strategy. We’d have to go with robo-advisors—with their automatic rebalancing and the benefits of algorithms tracking asset correlations and allocation, they’re an accessible, easy-to-use way to get in on the benefits of MPT.

Robo-advisors even let you change the level of risk for your portfolio and adjust your assets accordingly—more risk, more potential payoff, and vice-versa. That’s not to say that you can’t utilize MPT on your own—you can, but be prepared to spend a lot of time researching and educating yourself if that’s your goal.

Problems with Modern Portfolio Theory 🚨

Modern portfolio theory does have its critics, however. In fact, some of the biggest names in investing, such as Warren Buffet and Charlie Munger of Berkshire Hathaway, aren’t fans of this theory.

Buffet has previously referred to diversification as protection against ignorance. While that might be a bit too harsh, it does ring true in certain respects. The same benefits can be achieved by using fundamental analysis and taking the time out to research stocks.

Even Buffet agrees that the concept of diversification as practiced in MPT is a reasonable choice for most investors—he’s simply of the opinion that with some time and effort, superior results can be achieved in a different way. However, learning how to analyze a business is a skill that requires a lot of practice—so MPT can function as a handy shortcut.

MPT does have other criticisms thrown at it, however. Chief among them is that MPT looks at portfolios through the lens of variance, rather than downside risk. A portfolio that suffers from frequent, yet small losses, and one that has infrequent, yet large drops, are equally as good according to MPT. 

That sort of logic just doesn’t play out in the real world—with a vast majority of investors preferring more common, yet smaller losses that are easy to manage. One of the ways that this criticism of MPT is addressed is through post-modern portfolio theory, which seeks to minimize downside risk in place of variance.

The “Efficient Market” is Inefficient 📉

One of the weakest points of MPT is its reliance on the efficient market hypothesis. That hypothesis states that because the rapid spread of information allows investors to rapidly alter the prices they are willing to buy and sell at, the market is always fairly priced.

A simple look at any bubble or stock market crash quickly dissuades that notion. Another point of the efficient market hypothesis worthy of criticism is that investors behave rationally—always choosing the optimal approach for themselves based on cost-benefit analysis. 

This obviously isn’t true— just look at the recent events regarding Gamestop—and worse still, the information available to investors isn’t always perfect. The widespread adoption of MPT has led the world of investing into a sort of groupthink. 

Everyone assumes that everyone is acting rationally, so following the herd becomes the norm—and all the while due diligence and analysis are swept aside. A large number of people blindly following the same trends leads to two things—large run-ups, and large crashes—neither of which are particularly tied to the reality of the underlying businesses.

Another important point to make is that correlations aren’t static. MPT bases its assumptions on historical data—and while this is better than nothing, there are no mechanisms that state that correlations will hold in changing market conditions. 

In fact, it has been demonstrated that correlations can and do change—particularly stock correlations, which move closer during crises. On top of that, new asset classes are hard to fit into the framework of MPT—just recently, stock market volatility has dragged the price of cryptocurrencies down—but we’re still not sure if that is a one-off.

Has Modern Portfolio Theory Worked in the Past? 🕰

Modern portfolio theory caused quite a stir when it first appeared. Although some investors weren’t too keen on Markowitz’s findings, in the end, MPT became the basis for long-term investing.

So, how has that worked out? Pretty good, all things considered. Large financial institutions that have the resources to carefully construct portfolios as well as research the underlying holdings in a detailed way have managed to utilize MPT quite successfully. Vanguard’s best performing portfolios, for example, have an average annual return of 9%—which is quite an achievement.

Another thing that speaks to the success of MPT is the rapid rise and adoption of robo advisors. All robo advisors utilize MPT, and quite a lot of them rebalance portfolios quite often. Although they cannot offer returns that rival those of a handcrafted portfolio, robo advisors can give investors quite impressive returns with little effort or risk involved.

Fidelity Go, for example, has reported two-year annualized returns of 7.26%. Wealthfront’s robo advisor has seen returns of 6.92% in the same period, with the rest of the competition reporting similar figures.

It’s clear that MPT has stood the test of time. It might not be the most exciting investment strategy, risk reduction is a wise approach. MPT is not immune to recessions—we’ll cover that down below, but that fact does not nullify the importance of diversification.

Modern Portfolio Theory During a Recession 🔻

Some of the main criticisms of MPT are to do with recessions. While it is true that correlations move closer during times of recession, Markowitz and the other authors who contributed to modern portfolio theory weren’t ignorant of this fact.

MPT doesn’t offer a one-size-fits-all solution. How a portfolio based on this theory will perform in a recession depends on the level of risk it adopts. It stands that low-risk portfolios perform better during crashes, but offer subpar returns during normal times and that higher-risk portfolios perform better when everything is fine, and accrue significant losses when a recession hits.

Ultimately, there is no straightforward answer to this question. What is clear, however, is that the basics tenets of MPT do hold true, even in times of recession—proper diversification and rebalancing are always desirable, regardless of market circumstances.  However, no amount of diversification can replace due diligence and researching the companies that you’re going to invest in.

While diversification might not be able to protect investors in times of crisis, there’s a chance it might—and that alone makes it worthwhile. Many of the criticisms of MPT fail to differentiate between the theory itself and how it is applied—of course, some funds constructed with MPT do fail, but that is unlikely to be caused by the theory, but rather by the specific mistakes made in applying it.

In Summary: Modern Portfolio Theory Pros and Cons 

Modern portfolio theory has had a profound impact on how investors, particularly institutional investors, approach the market. It has as many proponents as critics, as while it has proven to be a successful strategy, it isn’t without its flaws.

We can’t tell you if MPT will work for you – but we can, however, provide a simple rundown of the pros and cons of this influential theory.

MPT forces investors to properly diversify, and it has stood the test of time. It serves as a key ingredient in the investing strategies of large financial institutions across the world and has changed the way investors approach the market.

While its attempts to quantify and calculate risk are admirable, MPT is based on a set of assumptions that might be a little dated. The fundamental precepts of this theory are sound—diversification is a way to reduce risk, and, when possible, one should choose the least risky investment if their returns are the same.

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