Modern Portfolio Theory is an investment strategy first published in 1952 that’s since become popular with professional and average investors. Understanding that an investment’s potential returns are directly tied to the level of risk involved, modern portfolio theory (also known as MPT) offers investors a framework that can be used to construct a portfolio that is designed to maximize potential return while minimizing risk.
But what, exactly, is modern portfolio theory? How does it work? And how can investors use it in order to create the best investment portfolio for their unique financial goals?
What is Modern Portfolio Theory?
Modern portfolio theory was created and pioneered by Harry Markowitz with the 1952 publication of his essay “Portfolio Selection” in the Journal of Finance. Since then, in addition to eventually earning Markowitz the 1990 Nobel Prize in Economics, modern portfolio theory would come to be one of the most popular investment strategies in use today—more than 67 years later.
At its heart, modern portfolio theory makes (and supports) two key arguments: that a portfolio’s total risk and return profile is more important than the risk/return profile of any individual investment, and that by understanding this, it is possible for an investor to build a diversified portfolio of multiple assets or investments that will maximize returns while limiting risk.
These arguments are built upon an understanding of three key concepts: The risk-return relationship, the role of diversification in building an investment portfolio and something called the “efficient frontier.”
The Risk-Reward Relationship
All investments involve at least some risk (whether business risk, volatility risk, inflation risk, etc.) which can limit your investment gains or even lead to a loss of capital.
Simply put, there is no such thing as a guaranteed return or a completely safe investment. That being said, it is possible to rank investments and asset classes according to their riskiness. Certificates of Deposit (CDs) generally fall on the less risky side of the spectrum, stocks on the riskier side, and bonds somewhere in the middle.
While riskier investments bring with them a higher potential for loss compared to less risky investments, they also tend to bring with them a higher potential for gain. Conversely, less risky investments bring with them a lower potential for loss, paired with a lower potential for gain.
This concept is referred to as the risk-return relationship, which informs most investment strategies—including modern portfolio theory.
According to the tenets of modern portfolio theory, an investor’s ideal portfolio will be the one that maximizes their potential for return, while minimizing risk—or at least keeping the portfolio’s risk within an acceptable range.
Constructing this ideal portfolio will require a certain level of diversification.
The Role of Diversification
Once the risk-return relationship is understood, it must be accounted for. Typically, this is achieved through diversification: The process of constructing a portfolio out of different investments in order to reduce the exposure risk of holding too much of a single investment.
There are many different ways in which an investor might choose to diversify their portfolio in order to mollify this risk. You might diversify within asset classes—by investing in stocks from multiple companies, for example—or between asset classes—by investing in a mix of different stocks and bonds. Generally speaking, an investment portfolio with more diversification will carry less risk than an investment portfolio with less diversification.
Exactly how diversified an individual investor’s portfolio should be, and the assets that it should consist of, will depend on the individual goals and risk tolerance of the investor.
The ideal portfolio will be the one that maximizes the potential for return while minimizing the risk of loss. The portfolio will be only as risky as it needs to be in order to realistically achieve the investor’s desired returns. This concept is often referred to as the “efficient frontier,” which forms the bedrock of modern portfolio theory.
How Modern Portfolio Theory is Used by Investors
In seeking to build an investment portfolio that falls along the efficient frontier to build their investment portfolio, an investor who follows modern portfolio theory is typically working towards one of two goals.
Some investors are incredibly risk-averse. These investors are driven by a primary goal of limiting their potential for loss. Their secondary goal, though, is to grow their money as safely as possible. Risk-averse investors who understand the level of risk that they are comfortable accepting from their investments (their risk tolerance) can use modern portfolio theory to build a portfolio which falls within their acceptable risk range but also maximizes returns.
Other investors are comfortable taking on any level of risk in order to reach their investment goals. Their primary goal is growth. But even the most risk-tolerant of investors likely has at least some desire to limit their risk. Why take on more risk than is necessary to reach your goals? Investors who know their investment goals can use modern portfolio theory to create a portfolio that has the greatest likelihood of reaching their investment goals while only taking on as much risk as is necessary.
How You Can Leverage Modern Portfolio Theory in Your Investment Strategy
If all of this sounds confusing, you’re not alone. Understanding risk, standard deviation, expected return, and other economic concepts and principles, and using them to create an efficient portfolio can be difficult for professional investors and economists—never mind the average investor.
Luckily, it’s possible to take advantage of modern portfolio theory even if you don’t have a degree in finance. Simply by understanding the risk-return relationship and importance of diversification, an investor can make smarter investment decisions that minimize risk while maximizing returns. Exchange-traded funds (ETFs) and mutual funds, which can contain shares of hundreds of stocks or bonds, make it easier than ever to ensure that your portfolio has an appropriate level of diversification for your needs.
Additionally, many financial institutions, advisors, and robo-advisors leverage modern portfolio theory to determine allocation strategies for their clients and customers—including Acorns. Harry Markowitz, the father of modern portfolio theory, is in fact an investment committee advisor for Acorns.
* Keep in mind that investing involves risk including loss of principal. The foregoing is presented for educational use only and is not a recommendation to buy or sell any specific security or invest in any particular strategy.