Modern Portfolio Theory (MPT)
Modern Portfolio Theory (MPT) is an investing model where the investor attempts to take minimal level of market risk to capture maximum-level returns for a given portfolio of investments. However, although widely used within the financial industry, there are recent criticisms and variations of style to consider before applying MPT to your own investment portfolio and strategy.
Modern Portfolio Theory (MPT), a hypothesis put forth by Harry Markowitz in his paper "Portfolio Selection," (published in 1952 by the Journal of Finance) is an investment theory based on the idea that risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. It is one of the most important and influential economic theories dealing with finance and investment. Also called "portfolio theory" or "portfolio management theory," MPT suggests that it is possible to construct an "efficient frontier" of optimal portfolios, offering the maximum possible expected return for a given level of risk. It suggests that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification, particularly a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.
Modern Portfolio Theory (MPT) makes four key assumptions: • A rational investor chooses greater value over less value. • A rational investor chooses less risk over more risk. • An investment goal may be supported by more than one optimal portfolio. • The probability of success increases over time with diversification.
In financial markets, it is now standard and accepted practice to apply MPT to the development of investment instruments. Most retirement plans for example offer one or more versions of an investment strategy based on MPT. In 1981, Warren McFarlan applied the concepts of MPT to evaluating and selecting information systems projects and development initiatives (1981). McFarlan focused on the area of risk assessment at both the project and portfolio level and noted that risk is inherent in any project or portfolio and, in and of itself, risk is neither good nor bad. It is the determination of the degree of risk and the risk compared to the potential reward that are the critical factors in project selection. At the portfolio level, a balance of risks should exist across all projects with some projects having low risk factors and other having higher risk. It is the balancing of risk that generates the highest return over time with an IT investment portfolio.
Limitations of Modern Portfolio Theory
Modern Portfolio Theory takes in to account many assumptions which are not always correct in the real world. As an example, the theory assumes that asset returns are normally distributed random variables. A real life examination indicates this is often far from true. In many cases there are many large swings which invalidates the theory. Another major flaw in the theory relates to the assumption that all investors have access to the same information. This is far from true. Many online publications such as Wall Street Journal or Bloomberg charge members to access their sites. Investors who do not pay an additional fee can be left in the dark when it comes to news. As always, as an investor it is best to never jump to one conclusion based on one theory. An overall analysis should include much more information than just an efficient frontier.