What Is a Modern Portfolio Theory

Modern Portfolio Theory

The perfect investment does not exist. However, if it were possible to have one, its attributes should include high returns and low risk. Of all the methods and strategies that a lot of people have come up with, none of it were as renowned s the Modern Portfolio Theory (MPT). The MPT is not perfect, but it is the theory that enables an investor to reap the benefits of diversification. Here in this article, we look at the basic concepts and terms behind MPT and how important this theory is for your portfolio management.

What Is Modern Portfolio Theory?

The Modern Portfolio Theory (MPT) is pioneered and developed by Nobel prize awardee Dr. Harry Markowitz. The MPT explains how risk-averse investors can construct and design financial portfolios for optimization. The MPT wants to prove that looking at investments individually is not enough?one has to see it as a whole portfolio to reap greater returns in the end.

modern portfolio

Importance of Modern Portfolio Theory

The idea of the MPT is not to lower your expected returns. To easily achieve and maximize your desired returns, the MPT encourages you to choose different types of investments that can diversify your risk. For instance, you solely invested in stocks. You put yourself in the position where you are at the mercy of the stock market alone, and if stocks generally drop, you will definitely face serious and what’s even worse is that you have nothing to offset it with.

One way of diversifying is by investing in both stocks and bonds so, in the event that one drops, the other one may increase and help you offset and avoid a complete loss. Just make sure that when you diversify your portfolio, choose investments that are not correlated or are not within the same sector. The risk of having investments in various industries is lesser than investing in a single industry or investment type.

importance of modern portfolio theory

Types of Portfolio Management

One of the corporate financial essentials includes a complete investment portfolio. And one of the things you should know in order to complete one is to know the various types of portfolio management. These are briefly discussed below.

  1. Active Portfolio Management: This type of portfolio management aims to make better returns in contrast to what the market hypothesizes. In doing so, active managers would buy stocks with lower value and would sell it once it climbs above the norm.
  2. Passive Portfolio Management: This type of portfolio management involves a passive investing strategy that follows the efficient market hypothesis. In doing so, passive managers would invest in index funds since these have a low turnover but have good long-term worth.
  3. Discretionary Portfolio Management: With this type of portfolio management, the discretionary manager is given a full leeway when it comes to making decisions on behalf of the investors. It is under the discretion of the manager as to which strategy he or she thinks best to adopt.
  4. Non-Discretionary Portfolio Management: With this type of portfolio management, the manager here is simply the financial counselor who would advise investors as to which routes that investors should follow and take. The counselor would then outline the pros and cons, and it will already be up to the investor as to what path he should take.

types of portfolio management

Issues With Modern Portfolio Theory

An investment portfolio is one of the corporate finance essentials, so it is necessary to have basic knowledge regarding the issues with MPT. No theory is perfect, and just like any other existing theory, the MPT also has its own issues. One of the issues of the MPT is that RIAs or Registered Investment Advisors would tend to keep its investors locked into investments basing on forecasting models that are not in sync to the constantly changing market conditions. This results in the fact that advisers do not take the right risks that help their clients in achieving their long-term investment goals. Another issue with the MPT is that it does not take into account the changing risk in the market. The MPT does not also indicate as to when and how the portfolio should be rebalanced.

That being said, MPT has some shortcomings in the real world. For starters, it often requires investors to rethink notions of risk. Sometimes it demands that the investor take on a perceived risky investment (futures, for example) in order to reduce overall risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated portfolio management techniques.

issues with modern portfolio theory

Risks of Modern Portfolio Theory

One of the personal finance essentials includes achieving financial portfolio optimization. The MPT has two components of risks for individual stock returns that you might possibly encounter when conducting a financial risk analysis. These are laid out below

  1. Systematic Risk: These are the risks that can hardly get reduced through diversification. This is because of the possibility that the entire market and economy will have losses that can affect investment in a negative manner. Among the examples of systematic risks include interest rates, recessions, and wars.
  2. Unsystematic Risk: These are the risks that can be diversified once you increase the number of stocks in your investment portfolio. This risk is also known as specific since these risks are specific to individual stocks. Examples include a decline in operations are a change in the management.

Modern Portfolio Theory and Risk Management

You have to understand that when you invest in financial markets, expect that along with it are significant levels of risks. Through the MPT, investors are offered a framework that they can use in risk management and in achieving financial portfolio optimization, and that is through diversification, asset allocation, and rebalancing. Through these, an investor can come up with a portfolio that maximizes the potential of returns while avoiding or minimizing risks.

modern portfolio theory and risk management

Investment and Modern Portfolio Theory

The MPT encourages investors that they should invest in more than one stock in order to reap the benefits of diversification, which is the reduction of risks in one’s portfolio. Additionally, the MPT also shows that making investments is not simply about picking multiple stocks, but it also involves effective decision-making as to determining the right combination of investments.

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