Modern Portfolio Theory

What Is Modern Portfolio Theory?

Modern portfolio theory is an investing model designed to help investors structure a portfolio that seeks to maximise returns with a minimal level of risk, largely through diversification.

Who Created Modern Portfolio Theory?

The theory was devised by Harry Markowitz in an article entitled "Portfolio Selection" published in the Journal of Finance in 1952. In the article, he quantified a method for constructing such a portfolio, and in 1990 he was awarded the Nobel Memorial Prize in Economic Sciences for his work.^[1]

Markowitz wasn't the first person to recognise the importance of diversification. However, his theory was the first to help investors construct a portfolio—through a mathematical formula whose expected results could be plotted on a graph—that could deliver an optimum level of return given a certain risk level.^[1]

The basis of Markowitz's theory is that investors can hold a variety of securities and asset types in their portfolio, and each is high in risk but offset or balanced by the risks in the other investments until the portfolio reaches an "efficient frontier"—or the optimum level of return given a desired level of risk. He devised a methodology to arrive at that point based on each asset's expected return, its weight within the portfolio and its level of riskiness.

The more risk-averse a portfolio, the lower the expected returns. Conversely, higher risk portfolios can be expected to produce greater returns. Markowitz's theory helped investors find the "sweet spot" between their desired level of risk and their expected returns.

Example Of Modern Portfolio Theory

In its most well-known real-life example, investors hold both stocks and bonds in their portfolio because, historically, stock prices rise when bond prices fall, and vice versa. Bonds should cushion any decline in stock prices. A portfolio of all stocks and no bonds, then, would be vulnerable to a downturn in the stock market, with no other securities or asset types to offset any losses. The same would especially be true if the portfolio consisted of just one stock. A portfolio of several stocks would at least provide some level of diversification of risk, while just one stock would provide no protection.

For example, electric power utility companies generally do better when the price of energy is low, which is usually negative for oil companies. Conversely, high oil prices benefit energy companies while making it more expensive for utilities to operate, thus hurting their profitability. So, gains and losses in energy stocks and utilities can be expected to offset each other to some degree. By the same token, value stocks and growth stocks generally move in and out of favour inversely to each other.

In addition, individual securities in the optimum portfolio should be less correlated to each other, Markowitz theorised. Generally speaking, the price of oil has little correlation to the price of tobacco, so an event that affects energy stocks shouldn't have any impact on tobacco stocks.

Modern portfolio theory, then, is at the basis of portfolio management for long-term investors, such as those saving for retirement. The mix of different assets and securities in an individual's portfolio would depend on each person's comfort level for risk, which is often a function of their age and how many years they have left before they retire, as well as their own psychological makeup.

For example, people in or approaching retirement are usually advised to be more risk averse and hold a portfolio with a relatively high percentage of bonds versus stocks. Similarly, investors who can't stand the thought of losing money generally need a low-risk portfolio. Young people, by contrast, can take on more risk by holding fewer or no bonds and investing in growth stocks, as they have a longer investment horizon and are better able to absorb losses that can be made up over time.

Summary

Modern portfolio theory is an investing model designed to help investors structure a portfolio that seeks to maximise returns within a desired level of risk, largely through diversification. The theory was devised by Harry Markowitz in 1952, in which he quantified a method for constructing such a portfolio.

The basis of the theory is that investors can hold a variety of securities and asset types in their portfolio. Each is high in risk but offset or balanced by the risks in the other investments until the portfolio reaches an efficient frontier.