What is Modern Portfolio Theory?

Explanation

Modern Portfolio Theory (MPT) is an investing model in which investors invest with the motive of taking the minimum level of risk and earning the maximum amount of return for that level of acquired risk. The modern portfolio theory is a helpful tool for the investors as it helps them in choosing the different types of investments for the purpose of the diversification of the investment and then making one portfolio by considering all the investments.

According to modern portfolio theory, all the investments that are selected are combined together in a way that reduces the risk in the market through the means of diversification and, at the same time, also generates a good return in the long term to the investors.

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Example of the Modern Portfolio Theory (MPT)

There is an individual who wants to invest in a portfolio. He got an option of two portfolios, which are as follows:

  • The first portfolio consists of a mix of the bonds and different stocks that gave the return of 10 % annually on an average, but at the same time differed by the range of as much as 15 % annually (returns, in this case, usually differed between -5 % and + 25 %).On the other hand, the second portfolio consists of a mix of the bonds and different stocks that gave the return of 10 % annually on an average, but at the same time differed by a range of only 3 % annually (returns, in this case, usually differed between 7 % and 13 %).

According to modern portfolio theory, which investment portfolio should a person consider?

Analysis

  • In both scenarios, the average expected return on the investment is 10 %. However, in the first portfolio, one could get the return of as much as 25 %, which sounds attractive, but at the same time, there prevails a huge risk where one might lose 5 % as well because the range usually differs between -5 % and + 25 %.On the other hand, in the case of the second portfolio, a less return range of between 7 % and 13 % may be less attractive to the investor, but in that case, it is expected that one will not lose his money, which makes the investment less risky than the first portfolio.According to Modern portfolio theory, an investor invests with the motive of taking the minimum level of risk and earning the maximum amount of return with that minimum risk taken, so in the present case, one should choose the second portfolio as he is getting the same average expected return with the less level of risk.

Assumptions of Modern Portfolio Theory

Modern Portfolio theory has a certain assumption that is to be considered while making any decisions in order to arrive at the conclusion that risk, return, and diversification relationships hold true. The different assumptions of the modern portfolio theory are as follows:

  • Returns from the assets are distributed normally.The investor making the investment is rational and will avoid all the unnecessary risk associated.Investors will give their best in order to maximize returns for all the unique situations provided.All investors have access to the same information.The cost pertaining to taxes and trading is not considered while making decisions.All the investors are having the same views on the rate of return expected.The single investors alone are not sizable and capable enough to influence the prices prevailing in the market.Unlimited capital at the risk-free rate of return can be borrowed.

Advantages of the Modern Portfolio Theory (MPT)

There are several different advantages of Modern portfolio theory providing the opportunity for the investors investing their money in the market. Some of the advantages are of the Modern portfolio theory as follows:

  • It helps in evaluating and managing risks and returns associated with the investments. With the help of analysis, the assets which are underperforming assets and the assets having an excessive risk with respect to returns can be scrutinized and then replaced with the new one.The theory is an important tool for avoiding financial ruin because by following these theories, traders don’t rely on only one investment for their financial stability; rather, they diversify their portfolio in order to get the maximum return with minimum risk.

Disadvantages of the Modern Portfolio Theory (MPT)

Along with the different advantages, there exist the limitations and drawbacks also of the Modern portfolio theory, which includes the following:

  • In the case of the modern portfolio theory, the past performance of the company under consideration is taken. The performance of the past never provides a guarantee for the result that could arise in the future. Considering only the past performances sometimes leads to overpassing the newer circumstances, which might not be there when historical data were considered but could play an important role in making the decision.This theory assumes that there is a normal distributionNormal DistributionNormal Distribution is a bell-shaped frequency distribution curve which helps describe all the possible values a random variable can take within a given range with most of the distribution area is in the middle and few are in the tails, at the extremes. This distribution has two key parameters: the mean (µ) and the standard deviation (σ) which plays a key role in assets return calculation and in risk management strategy.read more of the return on an asset within a class of assets, which is proved to be wrong for individual equities as the correlations of asset class may change over the period of time.In this theory, there is an assumption that securities of any of the sizes can be bought and sold, which doesn’t hold true as some of the securities have minimum order sizes, which cannot be dealt with in the fraction.Modern Portfolio Theory even though is accepted widely all over the world and also applied by different investment institution, but at the same time it has also been criticized by different persons particularly by representatives of the behavioral economicsBehavioral EconomicsBehavioural economics refers to a stream of mainstream economics that studies the impact of human psychology, ideology or behaviour on the individual or institutional economic decision-making process.read more who challenges the assumptions of the Modern portfolio theory on the parameters of investor rationality and the expectations for the return.

Conclusion

The main idea or the purpose of the Modern portfolio theory says that the risk is undertaken and returns are linked directly, which means that in order to achieve the greater rate of expected returns, an investor must have to take a higher level of risk. Also, the theory says that the overall risk of the portfolio having securities can be reduced through the means of diversification. In case two different portfolios are given to the investor having the same level of expected returnExpected ReturnThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability. read more, then the rational decision would be to choose the portfolio having lower total risk.

Modern Portfolio Theory, even though it is accepted widely all over the world and also applied by different investment institutions, but at the same time, it has also been criticized by different persons. However, regardless of the different criticisms, Modern portfolio theory is a working strategy having a diversified investmentDiversified InvestmentA diversified portfolio of investments is a low-risk investment plan that works as the best defence mechanism against financial crises. It allows an investor to earn the highest possible returns by making investments in a mixture of assets like stocks, commodities, fixed income.read more that is implemented by different risk managers, investment institutions, and related persons.

This has been a guide to Modern Portfolio Theory (MPT) and its definition. Here we discuss key assumptions of Modern Portfolio Theory along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles

  • Portfolio Diversification MeaningPortfolio Return FormulaPortfolio Standard DeviationTypes of Asset ClassesQuantamental