Modern Portfolio Theory (MPT)

Modern portfolio theory (MPT) also referred to as mean-variance analysis, is a theory with a mathematical framework for putting together a portfolio of assets in order to optimize expected return based on a given level of market risk.

When it comes to investing in the capital market, all hands are on deck to ensure that you do not lose too much money while trying to make money. And while the concept of risk and return is clear enough, there are a wide range of strategies based on different aspects of portfolio management to help you strike this balance.

Modern Portfolio Theory is not just one of them, but one with a perspective broad enough to serve as an umbrella for other portfolio management strategies – with the addition that it can get a little too technical.

Modern portfolio theory (MPT) also referred to as mean-variance analysis, is a theory with a mathematical framework for putting together a portfolio of assets in order to optimize expected return based on a given level of market risk. Basis of the theory is that risk is an inherent part of reward.

This theory was created by Economist, Harry Markowitz in his paper "Portfolio Selection," and because of this theory, he received a Nobel Prize. His basis for the creation of the strategy was that available strategies simply focused on return but did not account for risk.

Also, the goal of the theory is to help investors who are risk-averse.

The theory feeds off from the concept of diversification that we all know of – having different kinds of securities in different industries is less risky than having just only one type in one industry, thus focusing not on one asset but on the success of the overall portfolio.

The idea was that investors saw risk and return as directly related with returns in that they need to take a higher risk in order to receive higher returns. However, the theory posits that investors can create an “efficient frontier” that achieves the maximum expected return for a minimum level of risk.

It suggests that the investor should choose the portfolio with the lower risk without sacrificing the return. It employs statistical measures like variance and correlation to prove that an individual investment's return is less important than how the investment behaves in with the rest of the portfolio.

The theory show that there is a formula to maximize investment returns and minimize risk and this formula would aid the investor in taking minimal level of market risk towards obtaining maximum-level returns for a given portfolio of investments.

Even though the portfolio is widely used within the financial industry, there are a few criticisms and things to take into consideration before incorporating it to your own investment portfolio and strategy.

The first and most important criticism lies in the formula itself. Should there be a technically-induced analysis to determine spot on asset allocation? In the stock market, attempts at devising systems to determine an outcome can be a waste and it can also give the investor a sense of bleak assurance.

As such, the criticism is based on the fact that MPT uses technical analysis and trends as opposed to the usual buying and holding. The basis of the theory, however, is sound. Diversification would always be key, and the investor must be cognizant of the risk and return tradeoff.

Written by Lawretta Egba.