In the stock market, you have to weigh the potential for gain against the risk you’re willing to take. It is common knowledge that high-risk investments yield higher returns than their low-risk counterparts.
It is common practice for investors to evaluate a potential purchase based on the investment’s risk and potential return. That conventional wisdom is flipped on its head by the Modern Portfolio Theory.
According to this school of thought, investors shouldn’t pick individual assets based on their risk/reward characteristics; rather, they should consider how those investments would affect the overall risk/reward profile of their portfolio.
How Does Modern Portfolio Theory (MPT) Work?
In 1952, American economist Harry Markowitz proposed a model for portfolio selection in the Journal of Finance that he called the Modern Portfolio Theory (MPT). Subsequently, Markowitz received the Nobel Prize in Economics for his contributions to the theory.
All investors are assumed to be risk-averse in the sense that they would prefer a strategy that promises higher returns with reduced exposure to danger. This assumption has been repeatedly verified.
There is no need to take into account an individual’s risk tolerance when selecting investments for a portfolio if all investors are assumed to be risk-averse. Instead, investors should use MPT to find assets that can boost returns, lower risks, or do both in a diversified portfolio.
The best portfolio using this approach would hold both high-risk and low-risk investments, with a careful balance between the two to maximize return while minimizing risk. The objective is to increase returns while reducing the portfolio’s total risk.
When constructing a portfolio, multiple asset classes are utilized, with the variance and correlation between them being given particular attention.
- Variance. The variance of a dataset describes the spread of its individual values. As a measure of risk, variance is calculated by comparing the difference between the most likely and least likely outcomes (reward).
- Correlation. How two or more assets behave in tandem is referred to as their correlation. For example, when the value of gold rises, the value of Treasury bonds tends to rise as well, and vice versa. However, as Treasury bond prices rise, stock prices typically fall, and vice versa, due to the negative correlation between the two asset classes.
Keeping all that in mind, suppose you have a portfolio consisting entirely of Treasury bonds. Your portfolio’s minimal risk would also mean it can’t grow as much. Similarly, when the market is doing well, Treasury bonds tend to decline. The bond-only portfolio presents a poor risk-reward ratio.
If you subscribe to Modern Portfolio Theory, even a little allocation to high-risk, high-reward equities like small-cap value stocks could be quite beneficial to your portfolio. These equities have a reputation for extreme volatility and pose a much higher risk than Treasury bonds.
A Treasury bond-heavy portfolio can benefit by adding a 10% allocation to small-cap value stocks because of the latter’s lower volatility and higher return potential.
This is due to the fact that Treasury bonds will experience price fluctuations, but at a lower frequency and in the opposite direction of stock markets. During times of bond market weakness, small-cap value stocks can help offset losses and even generate profits. When the portfolio’s equities go down, however, the Treasury bonds help to offset the loss.
In contrast, let’s imagine all of your investments are equities. If you take on such a high degree of risk, you could potentially earn a pretty high rate of return. Market volatility can be mitigated and the impact on prospective returns minimized by including some Treasury bonds in the mix.
How Is the Relationship Between Risk and Reward Modeled by Modern Portfolio Theory?
The efficient frontier is the central principle of Modern Portfolio Theory, a widely used strategy for diversification. When numerous portfolios are plotted on a graph and an upward-sloping line is drawn to connect them, we have constructed the efficient frontier.
To locate the efficient frontier, investors must first construct a number of portfolios and evaluate them in terms of their risk as assessed by the portfolio’s annualized standard deviation and reward as measured by the portfolio’s compound annual growth rate, or CAGR.
Let’s pretend that Portfolio A has a standard deviation of 8% per year and a CAGR of 9%, Portfolio B also has a standard deviation of 9% per year and a CAGR of 9%, and Portfolio C also has a standard deviation of 6% per year and a CAGR of 8%.
The efficient frontier for these portfolios can be calculated by plotting the values against a risk/reward (X) and time horizon (Y) graph. The efficient frontier is an upward-sloping line that passes through the center of the plotted points.
The efficient frontier is the median or middle line on a graph depicting the risk and return of multiple portfolios. In your scatter plot, you’ll see some portfolios to the left of the efficient frontier, while others to the right.
A successful portfolio is one that maximizes profits while taking only the required amount of risk, placing it over the efficient frontier line. Portfolios to the right of the efficient frontier have a higher risk in comparison to the returns they create, whereas portfolios to the left have a lower risk.
Advantages and disadvantages of Modern Portfolio Theory
MPT has advantages and disadvantages like any other type of investment approach.
Advantages of Contemporary Portfolio Theory
It’s not often that a person receives a Nobel Prize for their investment strategy. There is undoubtedly plenty to gain by adhering to the MPT.
These are just a few of the many amazing advantages:
- Improvements in the Portfolio’s Performance. Obviously, when you invest, you’re hoping to increase your financial standing. To help investors maximize their returns on the stock market, this tactic was developed.
- Minimal Danger. When you diversify your portfolio with numerous assets that are negatively correlated, you lessen your exposure to market fluctuations and increase your returns.
- Insist on having a wide variety of investments. Diversified investment portfolios are highly recommended by industry experts since they assist mitigate financial losses when things inevitably go wrong. This method offers a great deal of security as a result of the focus it places on diversification.
Disadvantages of Modern Portfolio Theory
Before incorporating the MPT into your investment strategy, you should weigh its potential benefits against its disadvantages.
- Exposure to Investment Variability. Instead of focusing on negative risk, the MPT analyzes variability. The same standard is used for two portfolios if their returns and standard deviations are identical. This also means that a portfolio that has tiny decreases on a regular basis is handled in the same way as one that experiences large declines on rare occasions. A significant, unexpected reduction in value is too distressing for most investors and can lead to emotional investment, therefore a portfolio with lesser declines is the best alternative. So, one portfolio is obviously riskier than the other, despite the fact that they are both measured the same using MPT.
- Acquiring the requisite technical know-how. To use this strategy, investors need technical expertise in areas like standard deviation, asset collections, and compound annual growth rates. So, it’s a difficult tactic to learn for freshmen.
Post-Modern Portfolio Theory against Modern Portfolio Theory (MPT) (PMPT)
The foundation of MPT is the premise that a diversified portfolio should contain both low-risk and high-risk holdings. According to the notion, when adding assets to a portfolio, the goal should be to boost return potential without increasing risk.
A distinct perspective on risk is taken in the Post-Modern Portfolio Theory (PMPT), which does not dispute these ideas. A 10% drop over the course of a day is equivalent to a series of smaller declines that add up to 10%, according to Modern Portfolio Theory.
However, investors should stay away from equities that have had such drops because of their extreme volatility. The PMPT takes an asymmetrical perspective of risk, placing more importance on the possibility of huge losses than on the likelihood of several smaller losses.
Should You Model Risk and Reward Using Modern Portfolio Theory?
The MPT is still widely used today despite its creation and publication in 1952. Most investors currently do business under the theory’s fundamental assumption. It is common advice for new investors to diversify their holdings between equities and bonds.
This is done to maximize the portfolio’s potential for both safety and growth. As a high-risk asset, stocks come with a higher return on investment, while bonds offer security with a lower risk. This is the fundamental idea behind Robo-advisors and other popular investment methods.
The only difference is that if you put MPT into effect, you can rest assured that any new investments you make will fall outside of the inefficient frontier. Assuming you’re an investor, you should absolutely do this.
When making an investment, it’s important to weigh the potential benefits against the possible losses. Investing always involves some level of risk. Holding cash exposes you to the risk of depreciation due to fluctuations in the value of the dollar and inflation.
Risk and reward are addressed in an approachable manner in MPT. You can ensure your financial future by investing in assets that are negatively linked with one another, as this will lower the portfolio’s exposure to volatility while still exposing it to possible rewards.