Modern Portfolio Theory: Real-World Applications

Breaking Down Modern Portfolio Theory: A Practical Guide

When it comes to making investment decisions, there’s a lot of theory out there that can seem confusing and daunting. But don’t worry, we’re here to break it down for you! In this blog post, we will discuss modern portfolio theory (MPT) and how you can use it in the real world. MPT is a mathematical model that helps investors determine the best mix of assets to achieve their desired return while minimizing risk. Understanding the role of 'investment portfolios' in the context of MPT is crucial, as it aids investors in optimizing their asset mix to achieve desired returns with minimized risk, diversifying investments, and analyzing the performance of these portfolios based on their risk-adjusted returns. Sound complicated? Don’t worry, we’ll explain everything! Stay tuned for our next post in the series where we will explore how to put MPT into action.

What is Modern Portfolio Theory and the Optimal Portfolio

Literature across the ages from the investing canon is generally in agreement that risk and reward are strongly correlated: in an efficient market, you have to bear more risk in order to see a larger return on your investment. This correlation allows us to derive a trend line & graph, showing the expected return for a given level of risk, or the level of risk required for a given return. The line itself represents the efficient frontier, a concept central to Modern Portfolio Theory (MPT), where the most efficient or risk-optimized portfolio allocations for various anticipated returns are depicted. Portfolios that lie on or above this efficient frontier line represent optimal portfolios that offer the highest return for a specified level of risk, emphasizing the importance of portfolio selection in achieving an ideal portfolio configuration. The capital market line extends from the risk-free rate to the point of tangency on the efficient frontier, illustrating the best possible combination of risk-free and risky assets. Adding a risk-free asset to a portfolio, such as short-term government securities with a fixed risk-free rate and exceptionally low default risk, can shift the efficient frontier, creating a new line of optimal portfolios. This introduction of a risk-free asset and the consideration of risky assets in achieving diversification are crucial in optimizing the portfolio along the efficient frontier. This efficient frontier takes into account MPT, or modern portfolio theory, an idea pioneered by economist Harry Markowitz in the 1950s. It states that it’s possible to design an ideal portfolio, through careful portfolio selection, that will provide the investor maximum returns by taking on the optimal amount of risk. MPT assumes investors are risk averse, meaning they prefer to minimize risk for a given level of expected return, and thus, rational risk-averse investors should aim to hold portfolios that fall on the efficient frontier to secure the highest possible expected returns for a given level of standard deviation.

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How MPT Can Be Applied in Real-World Portfolio Management

One of the key aspects to understanding MPT is diversification. By mixing investments across different asset classes with a variety of risk-return profiles, each investor can reach the optimal portfolio allocation that suits their idiosyncratic needs. This rests on the premise that through portfolio diversification, you can maintain the return profile of your investments while limiting the downside and effectively reduce risk.

Now that we know what MPT is and how it works, let’s explore how we can use it in the real world. portfolio theory application

There are a few key concepts that you need to understand in order to apply MPT to your portfolio: expected return, standard deviation, and correlation.

• Expected return is the expected value of the probability distribution of possible returns from an investment over a period of time, reflecting the statistical basis of this concept.
• Standard deviation is a measure of risk that shows how much an investment’s return can differ from the expected return
• Correlation is a measure of how two investments move in relation to each other

Understanding these concepts allows you to create a portfolio tailored to your specific risk tolerance and investment goals. MPT, used in conjunction with other investment strategies such as asset allocation and diversification, aims to minimize market risk and maximize returns. Market risk, or the risk of losses due to factors that affect the entire market, is a key consideration in portfolio diversification. MPT seeks to manage this type of risk through strategic asset allocation, differentiating between market risk and specific risk and highlighting the importance of diversification in mitigating systematic risks within one market.

So you might calculate the expected return of your portfolio by calculating the weighted sum of the returns of individual assets. If a portfolio contained four equally weighted assets with expected returns of 3%, 5%, 7% and 9%, the portfolio’s expected return would be:

(25% x 3%) + (25% x 5%) + ( 25% x 7%) + (25% x 9%) = 6%

This could be compared to the standard deviation of the portfolio, which is a proxy for its level of risk.

The Pros and Cons of MPT and the Efficient Frontier

Benefits:

• Useful for investors who are trying to build diversified portfolios
• Useful for investors who are looking to invest in assets that are negatively correlated with their portfolio
• Encourages thinking about a well diversified portfolio and self-examination of your risk tolerance
• Can be used to diversify a portfolio in order to increase returns without a commensurate increase in risk

Drawbacks:

• The main criticism is that it evaluates portfolios based on variance rather than downside risk. So two portfolios with the same variance and return are considered equally desirable, even though one might have frequent small changes vs the other having infrequent wipeout losses
• Another significant limitation is its reliance on historical data for making future investment decisions. This approach assumes that past market performance is a reliable indicator of future outcomes, ignoring the fact that historical data may not accurately reflect new market conditions or unforeseen events, thus potentially leading to misguided investment strategies.

Final Thoughts on MPT

Overall, MPT is a helpful tool for investors who are looking to build a portfolio. However, it's important to understand the limitations of the theory and how it applies to your specific investment goals. If you're new to the idea, perhaps it might help to apply it to a small portion of your overall portfolio first, to get a feel for it, before using it more widely. We are working on making it as easy as possible to apply theoretical concepts to your own portfolio on the Strabo dashboard. For further updates on MPT and other portfolio construction strategies, sign up for the platform today at the foot of the page.