Modern Portfolio Theory (MPT) is an investment theory whose purpose is to maximize a portfolio’s expected return by altering and selecting the proportions of the various assets in the portfolio.
It explains how to find the best possible diversification.
If investors are presented with two portfolios of equal value that offer the same expected return, MPT explains how the investor will prefer and should select the less risky one.
Investors assume additional risk only when faced with the prospect of additional return.
In brief, MPT explains how investors can reduce overall risk by holding a diversified portfolio of assets.
Assumptions of MPT
• Asset returns are normally distributed random variables.
• Investors attempt to maximize economic market returns.
• Investors are rational and avoid risk when possible.
• Investors all have access to the same sources of information for investment decisions.
• Investors share similar views on expected returns.
• Taxes and brokerage commissions are not considered.
• Investors are not large enough players in the market to influence the price.
• Investors have unlimited access to borrow (and lend) money at the risk free rate.
• One of the most important and widely used concept of Modern Portfolio Theory
• Every possible combination of assets plotted on graph.
• Plots return % vs Risk % (Standard Deviation)
• Optimal portfolio lies on the efficient frontier curve (parabola).
• All individual assets represented by gold dots are plotted inside the efficient frontier.
• The “tangency portfolio” represented by the red dot represents the most efficient combination of assets.
• The diagonal line represents a “risk free” asset- An asset that has a guaranteed return.
• The CAL (Capital Allocation Line) displays the return an investor should make by taking on a variable level of risk.
Limitations of Modern Portfolio Theory
Modern Portfolio Theory takes in to account many assumptions which are not always correct in the real world. As an example, the theory assumes that asset returns are normally distributed random variables. A real life examination indicates this is often far from true.
In many cases there are many large swings which invalidates the theory. Another major flaw in the theory relates to the assumption that all investors have access to the same information.
This is far from true. Many online publications such as Wall Street Journal or Bloomberg charge members to access their sites. Investors who do not pay an additional fee can be left in the dark when it comes to news.
As always, as an investor it is best to never jump to one conclusion based on one theory. An overall analysis should include much more information than just an efficient frontier.
Key Words: Modern Portfolio Theory, Expected Return, Diversification, Risk, Normally Distributed Variables, Rational Investors, Efficient Frontier, Risky Asset, Risk Free, Capital Allocation Line,