When it comes to making investment decisions, there's a lot of theory out there that can seem confusing and daunting. But don't worry, we're here to break it down for you! In this blog post, we will discuss modern portfolio theory (MPT) and how you can use it in the real world. MPT is a mathematical model that helps investors determine the best mix of assets to achieve their desired return while minimizing risk. Sound complicated? Don't worry, we'll explain everything! Stay tuned for our next post in the series where we will explore how to put MPT into action.
What is Modern Portfolio Theory
Literature across the ages from the investing canon is generally in agreement that risk and reward are strongly correlated: in an efficient market, you have to bear more risk in order to see a larger return on your investment. This correlation allows us to derive a trend line & graph, showing the expected return for a given level of risk, or the level of risk required for a given return. The line itself represents the Efficient Market Frontier, where the optimal portfolio lies. This line takes into account MPT, or modern portfolio theory. An idea pioneered by economist Harry Markowitz in the 1950s, it states that it's possible to design an ideal portfolio that will provide the investor maximum returns by taking on the optimal amount of risk.
How MPT Can Be Used in the Real World
One of the key aspects to understanding MPT is diversification. By mixing investments with a variety of risk-return profiles, each investor can reach the optimal portfolio allocation that suits their idiosyncratic needs. This rests on the premise that by diversifying, you can maintain the return profile of your investments while limiting the downside.
Now that we know what MPT is and how it works, let's explore how we can use it in the real world. portfolio theory application
There are a few key concepts that you need to understand in order to apply MPT to your portfolio: expected return, standard deviation, and correlation.
- Expected return is the average return you can expect from an investment over a period of time
- Standard deviation is a measure of risk that shows how much an investment's return can differ from the expected return
- Correlation is a measure of how two investments move in relation to each other
By understanding these concepts, you will be able to create a portfolio that is tailored to your specific risk tolerance and investment goals. MPT can be used in conjunction with other investment strategies, such as asset allocation and diversification, to further minimise risk and maximise returns.
So you might calculate the expected return of your portfolio by calculating the weighted sum of the returns of individual assets. If a portfolio contained four equally weighted assets with expected returns of 3%, 5%, 7% and 9%, the portfolio's expected return would be:
(25% x 3%) + (25% x 5%) + ( 25% x 7%) + (25% x 9%) = 6%
This could be compared to the standard deviation of the portfolio, which is a proxy for its level of risk.
The Pros and Cons of MPT
- Useful for investors who are trying to build diversified portfolios
- Useful for investors who are looking to invest in assets that are negatively correlated with their portfolio
- Encourages thinking about a well diversified portfolio and self-examination of your risk tolerance
- Can be used to diversify a portfolio in order to increase returns without a commensurate increase in risk
- The main criticism is that it evaluates portfolios based on variance rather than downside risk. So two portfolios with the same variance and return are considered equally desirable, even though one might have frequent small changes vs the other having infrequent wipeout losses
Final Thoughts on MPT
Overall, MPT is a helpful tool for investors who are looking to build a diversified portfolio. However, it's important to understand the limitations of the theory and how it applies to your specific investment goals. If you're new to the idea, perhaps it might help to apply it to a small portion of your overall portfolio first, to get a feel for it, before using it more widely. We are working on making it as easy as possible to apply theoretical concepts to your own portfolio on the Strabo dashboard. For further updates on MPT and other portfolio construction strategies, sign up for the platform today at the foot of the page.