What is the Modern Portfolio Theory?
Beginning with Harry Markowitz’s essay: Portfolio Selection (1952) published in the Journal of Finance, the modern portfolio theory (MPT) has become one of the most important underpinnings behind any investment portfolio. Behind all the math and statistics lies the fundamental idea of diversification in an effort to avoid falling
victim to systematic risks. Essentially, like with most things, don’t put all your eggs in one basket even when it comes to investing. From a more technical perspective, if one assumes that all financial securities possess idiosyncratic risks, then a portfolio of a large number securities would inevitable be self-diversifying as each asset’s idiosyncratic risk would likely cancel each other out. However, as many would already intuitively know, that is just not true. Instead, risk between various securities may often be systematic. This means that various securities, ie. stocks of different companies, may and do often move in the same direction particularly if the companies are in the same industry or deal with the same customers or regulators. Thus, proper diversification has to account for the various relationships and covariances between each asset in any given portfolio.
This fundamental idea would propel numerous crucial models including the Portfolio Frontier (figure 1) that charts returns over standard deviation, as well as the use of Sharpe Ratios as a more accurate measure of performance.
Together, the introduction of the MPT shines light on the idea that portfolios should not be considered only based on their expected returns. Afterall, if it were, then one could simply adopt an infinitely high leveraged position to obtain infinitely profitable returns. Instead, like with any other aspect of finance, risk has to be taken into account. And only upon understanding that, either explicitly or even implicitly, can one truly create a good portfolio that balances the risks and returns in a manner that is suitable for the investor and or their constituents.
Mangram, M. E. (2013). A simplified perspective of the Markowitz portfolio theory. Global journal of business research, 7(1), 59-70.
Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77–91. https://doi.org/10.2307/2975974
Markowitz, H. M. (1991). Foundations of portfolio theory. The journal of finance, 46(2), 469-477.
Trinidad, C. (2022, February 5). Modern portfolio theory (MPT). Corporate Finance Institute. Retrieved July 9, 2022, from https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/modern-portfolio-theory-mpt/