It’s been said before: There is no risk-free investment. But many investors want to limit investment risk, while hoping to generate a decent return. One attempt to balance investment risk and reward is Modern Portfolio Theory, or MPT. The idea behind MPT is that it is possible to provide investor-targeted returns, by accepting an optimal amount of risk.
While Modern Portfolio Theory has its supporters, the idea behind it also has potential downsides and limitations investors should know.
Prior to the early 1950s, investors relied on risk/reward analyses of individual securities. It was believed that each stock, bond, or other security should be judged separately. If those assets demonstrated the right amount of return, without undue risk, they would be placed within a portfolio.
Nobel Prize-winning economist Harry Markowitz published his article, “Portfolio Selection” in the March 1952 edition of the “Journal of Finance.” The article’s gist was that diversification could reduce portfolio risk. Basically, he noted that just picking stocks isn’t enough. Instead, picking a variety of stocks for a portfolio, then measuring the risk of that collection, as a whole, would be a better method of investment.
Markowitz outlined two types of risk:
Systemic risk, which is influenced by interest rates, economic cycles, and even wars. Systemic risk can’t be diversified away.
Unsystematic risk, which is specific to individual stocks. This can include an increase in operational efficiency or a management change. Unsystematic risk can be diversified away by increasing portfolio size.
The MPT focuses on the difference – or covariance – between individual stocks’ risk level. This, in turn, helps outline overall portfolio risk.
The main takeaway of MPT is that losses experienced by individual assets likely won’t “crash” a portfolio, thanks to diversification. Diversification can also help reduce portfolio volatility, potentially generating fairly steady rates of return.
Another advantage of modern portfolio theory is that it can lead to more efficient portfolios. This is because calculations used to find a suitable blend of stocks, bonds, and other securities can lead to a portfolio that meets investor goals and objectives.
One main criticism of MPT is that portfolios are assessed on variance, rather than downside risk. Quick definition: variance is a measure of the volatility (or dispersion) of returns over time. The challenge of MPT is that two different portfolios could show the same variance levels, but for different reasons.
One might show variance because of small, frequent losses, while the other could demonstrate similar variance, because of two or three larger declines. Both variances fit into different investment strategies.
Another potential MPT issue is that it models expected returns based on mathematical calculations based on past data. But it doesn’t model market fluctuations. Furthermore, MPT doesn’t take extra costs into consideration, such as broker commissions or taxes.
Finally, modern portfolio theory assumes that investors are risk-averse, completely rational, and have realistic investment returns. Anyone who follows the stock market for any length of time understands that trades aren’t always conducted for rational reasons; emotion can drive irrational activities. Furthermore, some investors might actually like taking on extra risk, assuming higher rewards.
Modern Portfolio Theory has supported portfolio development since the mid-20th century. Investors have relied on the idea of diversification and variance to help balance their holdings in an attempt to manage risk while enhancing returns.
But it should be remembered that Modern Portfolio Theory is just that – a theory. Building an effective portfolio requires diverse considerations, and should also include input from a tax advisor or financial planner.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor. There is no guarantee that the investment objectives of any particular program will be achieved. Neither asset allocation nor diversification guarantee a profit or protect against loss in a declining market. They are methods used to help manage investment risk. Past performance is not a guarantee of future results. Investing involves risk, including the loss of principal. There is no guarantee that designing a portfolio using MPT will accurately reflect your tolerance to risk.