What is modern portfolio theory?
In short:
Modern Portfolio Theory (MPT) is an investment theory that argues an investor can construct a portfolio of assets where return can be maximized for a given amount of risk. A core assumption of MPT is the investor is risk-averse, that is, between two investments offering the same return the investor will choose the one which has less risk. It should be noted that the risk MPT is trying to reduce is firm-specific risk or unsystematic risk.
Modern Portfolio Theory leverages the idea of diversification to optimize risk/return.
Quick Example:
In-depth:
The core idea of Modern Portfolio Theory is that risk/return can be optimized better by using multiple assets instead of simply looking to an individual investment. In such a case the question is less about the riskiness of the individual assets and instead on how it affects the portfolio as a whole. What can be confusing is that the addition of a higher-risk individual asset might be used to actually lower the risk profile of the portfolio as a whole.
To find which assets should be added to a portfolio for a given amount of return and risk, the correlation of the potential asset to be added is compared with the assets in the portfolio. By combining non perfectly correlated assets in a portfolio systemic risk is reduced. For example, the price performance of oil companies and airlines are generally negatively correlated. That is when oil prices rise and increase earnings for oil companies, airlines which consume large amounts of oil products see their share prices fall as their operating expenses increase. When these two types of companies are in a portfolio they would offset some risk. However, they would still be susceptible to market-wide risk such as higher interest rates or a weak economy.
As seen above the emphasis in Modern Portfolio Theory is placed on the combination of companies in a portfolio instead of the individual company.
Explained Example
We can look at an example to better understand the quick example formula above. Let’s say an investor has a total amount of $8,000 to invest. They have identified two companies they want to invest in as well as the expected return for each company by itself and the percentage of their $8,000 they want to invest. The two companies are as follows:
Company A has an individual expected return of 7% with the investor wanting to invest $6,000. Company B has an individual expected return of 12% with the investor wanting to invest the remaining $2,000. The expected return of the portfolio would be as follows:
[($6,000/$8,000)*7%] + [($2,000/$8,000)*12%] = 8.25%
Efficient Frontier
The efficient frontier is a curve that describes the optimal combination of risk for a desired return. The goal of a rational investor using Modern Portfolio Theory would be to get their portfolio as close to this curve as possible. Likely their portfolio would lie within the curve, that is taking on more risk than what is optimal for a given amount of return.
As can be seen from the chart above, the percentage return lies on the y-axis and the amount of risk lies on the x-axis. In reality, an investor trying to employ modern portfolio theory may find it very difficult to optimize their portfolio for a variety of reasons. One reason is that is finding investments whose performance is sufficiently disconnected from each other is difficult. Another reason can come from the counterintuitive idea that adding “riskier” assets could actually reduce the risk of their portfolio.
Arguments Against MPT
The initial argument an investor may make against modern portfolio theory could be in how risk is defined. In the case of modern portfolio theory, risk is in relation to the price performance of an asset (let’s say a stock) when in actuality it could be soundly argued that this is a terrible measure of risk. For example, two companies may have similar share price movements which result in the same “risk” when looking at share price movement. However, one company may be selling an elastic product to a small consumer base while the other may be selling a more inelastic product to a larger consumer base. Without other considerations of each business, the second business is actually less risky than the first even though traditional measures of risk would call them equal.
An even stronger argument could be that in theory constructing a portfolio in accordance with modern portfolio theory may be possible, however, in reality finding companies to construct such a portfolio is difficult.
Additional resources on risk: What is Beta in Stocks
Additional resources on estimating returns: Capital Asset Pricing Model (CAPM)