Modern portfolio theory, or MPT, is a popular investment strategy that seeks to harness the power of diversification to minimize risk and boost returns.
MPT advocates that when constructing a portfolio, investors should take a holistic approach by buying a suite of different assets classes — like stocks, bonds, and alternatives investments — that aren’t correlated to each other. (For example, stocks zig while bonds zag.)
But modern portfolio theory takes asset diversification one step further. Investors should carefully mind an investment’s potential risk and return and how that may affect the overall risk-return of the entire portfolio.
MPT has worked successfully for many investors for decades. It’s credited for helping investors wall off their emotions (“the market’s going to crash!”) and to adhere to a long-term investment strategy.
Like all investing strategies, however, MPT isn’t perfect and can’t prevent you from losing money when the markets do crash.
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How Does Modern Portfolio Theory Work?
MPT’s heart and soul is diversification, which works with precision in the natural world, but can be applied to the investing world, as well.
By spreading your bets (the bigger the non-correlational spread, the better), you lower your risk. More correlation, more risk. That’s the first part of modern portfolio theory.
Under the second component, investors should view each asset selection not as a separate moving piece, but as an integral part of the entire portfolio.
MPT is all about the relationship between risk and return — and how much an investor is willing to stretch that relationship.
For example, an investor who has a low risk tolerance but who, of course, wants to make a profit may pick an exchange-traded fund (ETF) that tracks the S&P 500 index for broad exposure to the largest U.S. corporations and an index mutual fund that tracks the collective performance of U.S. corporate, municipal, and Treasury bonds.
Remember, stocks and bonds are non-correlated assets that typically move in opposite directions. This investor may allocate 60 percent to stocks and 40 percent to bonds. (This is a standard balanced portfolio that’s at the heart of MPT.)
Let’s say this investor now wants to make more money. That will require more risk, and that means allocating more money to stocks at the expense of bond exposure. This is still a diversified — albeit riskier — portfolio with a clear understanding of the risk-return tradeoff.
On the flip side, a good example of violating the tenets of MPT is an investor who greedily plows 100 percent of his money into stocks. There’s nothing to protect him if his bet turns south. Smart MPT investors who create portfolios with optimal diversification (or non-correlation) have reached what is called the efficient frontier.
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What Is the Efficient Frontier?
In 1952, University of Chicago economic student Harry Markowitz published his doctoral thesis that would evolve into modern portfolio theory. He would later win the Noble Prize for his work in 1990.
At the core of MPT is the efficient frontier, which is reached when a portfolio offers the greatest expected return for a given level of risk. Or just the opposite: a portfolio offers the lowest level of risk for a given level of return.
The efficient frontier is a confirmation of human behavior in that investors, purposely or by accident, build portfolios to garner the largest possible returns with the least amount of risk.
It’s nearly impossible to define the precise efficient frontier because portfolios are like snowflakes. No two are exactly alike.
Each portfolio reflects an individual investor’s unique emotions, goals, and values.
“The main lesson is that investors should choose portfolios that lie on the efficient frontier, the mathematically defined curve that describes the relationship between risk and reward,” as Stanford University finance expert Paul Pfleiderer puts it.
“To be on the frontier, a portfolio must provide the highest expected return (largest reward) among all portfolios having the same level of risk.”
Is MPT Just a Bunch of Hype?
Hardly. Estimates suggest that trillions of dollars are invested in the markets in accordance with the MPT protocol.
For financial advisers, MPT makes their jobs easier, as they can construct portfolios for their clients based on the special risk-return relationship.
When a client tells her adviser how much risk she’s willing to take on, the adviser can use MPT to build a portfolio that maximizes the expected return of the portfolio for a designated level of risk. If MPT was quackery, no way would the wealth management industry use it.
That said, MPT did receive heavy criticism in the aftermath of the financial crisis of 2008–2009. The markets plunged and investors lost trillions of dollars as most non-correlated assets became correlated.
Critics contend MPT failed investors, but that’s wrong. In fact, portfolios built on the MPT approach didn’t decline as much as non-MPT portfolios.
A diversified portfolio of stocks and high-quality bonds fell about 23 percent, compared with nearly 40 percent decline for non-diversified portfolios that were heavy on stock investments.
Again, MPT can’t save you from losses when markets plunge, but it sure can cushion the fall and limit losses.
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What Is MPT’s Downside?
Nothing’s perfect. The financial crisis exposed a critical flaw in MPT when it comes to asset correlations. MPT assumes that asset correlations remain constant. However, in reality, stocks and many bonds (of lower quality) fell in unison.
MPT also assumes investors have access to the same information and data to make the best choices in constructing portfolios. But the truth is, they don’t.
And there are other slights, too. MPT can’t predict market volatility and accurately price risk. Nor can it divine future market performance. Lastly, MPT assumes — wrongly again — that all investors are accurate, rational, and smart, and that they don’t influence the prices of assets. Reality suggests otherwise.
Why Modern Portfolio Theory Is Here to Stay
Despite its flaws, investors and their financial advisers will never abandon MPT. Diversification and controlling risk work well for long-term investors. MPT proved its mettle (limit loses) during the financial crisis. It will no doubt do so again during the next market implosion.
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In my opinion, no other buy-and-hold investment strategy trumps MPT. It’s the best and most efficient way to build lost-cost portfolios for cost-conscious investors. That’s why robo-advisers, which young emerging investors are turning to in droves at the expense of human advisers, have embraced MPT with gusto. Seems like the perfect fit, well at least in theory.