What is the Modern Portfolio Theory (MPT)?
While investing, one of the key factors people need to consider is the rate of return. A beneficial investment would have low risks and high returns, except it’s not always easy. While some economic changes might be easy to speculate on, sometimes predicting an investment’s future might be tricky. There have been strategies created to make the best out of an investment, and the modern portfolio theory (MPT) can be considered the most popular among them.
What is it Exactly?
Introduced by the economist Harry Markowitz in an essay in 1952, modern portfolio theory can be considered a method of diversification. Markowitz claimed that investors are more likely to choose the less risky option when given two portfolios offering the same potential return.
Modern portfolio theory is a solution-based strategy for this cautious approach, maximizing the expected investment return for a given estimated risk level. This theory, which suggests that a risk-averse investor actually can create a portfolio with a high expected return for a low-risk level, supports the inclusion of seemingly conflicting investments in the same portfolio. This provides diversification, thereby minimizing the risk exposure of a portfolio.
Identifying Risks with Modern Portfolio Theory
The combination of the modern portfolio theory and investment analysis can be defined as the concept of risk is divided into systematic risk and unsystematic risk, depending on whether the investor has the ability to control or limit the risk. Systematic risk arises from the system itself, which the investor cannot control, such as possible social, economic, and political changes. They are the source of systematic risk.
On the other hand, unsystematic risks are company or industry-related risks and can be eliminated through good diversification. Legal problems, successful or unsuccessful marketing campaigns and management changes are examples of unsystematic risks, which can also be referred to as corporate risks.
What is the Efficient Frontier?
The curve, called the efficient frontier, shows the optimal balance of risk and return by combining different investment points. It is the foundation of modern portfolio theory. The line shows the fusion of investments that provides the highest return with the least risk. When a portfolio deviates to the right of the efficient frontier, the risk is higher than the estimated return. When it falls below the angle of the efficient frontier, it offers a lower risk-return ratio.
Things to Consider
Modern portfolio theory focuses on the relationships among the assets in a portfolio, not just on the individual risk carried by each asset. The theory, which at the beginning assumed that high returns are only made through risky investment instruments, was later extended to include low-risk assets in the portfolio. However, it should be considered that estimations are often based on previous data, which might not be relevant to current market values.
Diversification does help a portfolio, but systematic risks reflect the overall market fluctuation, and they can’t always be avoided. This might not fall in line with the present-day investment plans. Two portfolios might show the same amount of risk stemming from different conditions.