What Is Modern Portfolio Theory MPT ?
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You own shares of Apple, Amazon, Tesla. Why not Banksy or Andy Warhol? Their works’ value doesn’t rise and fall with the stock market. And they’re a lot cooler than Jeff Bezos.
Get Priority Access The theory assumes that all investors are risk-averse investors in the sense that if there is a way to generate higher returns with less risk, the option would be appealing to investors. That assumption has proven true time and time again. Assuming all investors are risk averse means there’s no need to consider an individual’s risk tolerance while choosing investments to add to your portfolio. Instead, using MPT, investors should look for the assets that will either increase return potential, reduce risk, or both when added to a diversified portfolio. The optimal portfolio under this investment strategy includes a mix of high-risk and low-risk investments, balanced in a way that provides the most volatility protection and the highest potential return. The goal is achieving higher returns while accepting lower overall portfolio risk. Multiple asset classes are used when building a portfolio, with a special focus on their variance and correlation: Variance. Variance measures the difference between numbers in a dataset. Variance is used to gauge risk by determining the spread between the worst possible outcome (risk) and the best possible outcome (reward). Correlation. Correlation refers to how two or more assets react with each other. For example, Treasury bonds have a positive correlation with gold because both assets are known to increase in value under similar circumstances — when one goes up, usually so does the other, and vice versa. But Treasuries have a negative correlation with stocks, meaning when Treasury bonds are up, stocks tend to trend down, and vice versa. Considering the above, say you have a portfolio built of nothing but Treasury bonds. Your portfolio would be low risk, but would have limited upside potential. At the same time, Treasury bonds are likely to fall when the market is performing well. Your risk-reward profile in an all-bond portfolio is suboptimal. Under the Modern Portfolio Theory, your portfolio could benefit greatly from a small allocation to high-risk, high-reward equities like small-cap value stocks. These stocks are known for heavy levels of volatility and are significantly riskier than Treasury bonds on an asset-to-asset basis. However, by adding a 10% allocation of small-cap value stocks to a Treasury bond-heavy portfolio, you actually reduce total portfolio risk while increasing your earnings potential. That’s because Treasury bonds will move up and down, but at a slower pace and in a different direction than stocks. When your bond holdings are down, your small-cap value stock holdings will likely pick up the slack and potentially provide substantial gains. On the flip side, when the stocks in the portfolio are down, the Treasury bonds pick up the slack. On the other side of the coin, say you have a portfolio built of 100% stocks. Although your return potential would be relatively high, your risk will also be high. By mixing in a small amount of Treasury bonds, you’ll greatly reduce the risk associated with market volatility while limiting the downward drag on your potential gains.
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By Joshua Rodriguez Date March 18, 2022FEATURED PROMOTION
The stock market is a trade off between risk and reward — the level of reward you can expect often has a strong correlation with the level of risk you’re willing to accept. High risk investments are known for high returns, while low-risk investments generate lower returns. Traditionally, investors gauge each investment by the risk-versus-reward profile of the investment itself. The Modern Portfolio Theory turns that idea on its head. This theory suggests that investments should be chosen based on how they will affect the risk-and-reward profile of your investment portfolio as a whole, rather than the risk-and-reward metrics associated with each single investment.What Is Modern Portfolio Theory MPT
The Modern Portfolio Theory, or MPT, is a model for portfolio selection developed and published in the Journal of Finance by American economist Harry Markowitz in 1952. Markowitz was later awarded the Nobel Prize for his work on the theory.You own shares of Apple, Amazon, Tesla. Why not Banksy or Andy Warhol? Their works’ value doesn’t rise and fall with the stock market. And they’re a lot cooler than Jeff Bezos.
Get Priority Access The theory assumes that all investors are risk-averse investors in the sense that if there is a way to generate higher returns with less risk, the option would be appealing to investors. That assumption has proven true time and time again. Assuming all investors are risk averse means there’s no need to consider an individual’s risk tolerance while choosing investments to add to your portfolio. Instead, using MPT, investors should look for the assets that will either increase return potential, reduce risk, or both when added to a diversified portfolio. The optimal portfolio under this investment strategy includes a mix of high-risk and low-risk investments, balanced in a way that provides the most volatility protection and the highest potential return. The goal is achieving higher returns while accepting lower overall portfolio risk. Multiple asset classes are used when building a portfolio, with a special focus on their variance and correlation: Variance. Variance measures the difference between numbers in a dataset. Variance is used to gauge risk by determining the spread between the worst possible outcome (risk) and the best possible outcome (reward). Correlation. Correlation refers to how two or more assets react with each other. For example, Treasury bonds have a positive correlation with gold because both assets are known to increase in value under similar circumstances — when one goes up, usually so does the other, and vice versa. But Treasuries have a negative correlation with stocks, meaning when Treasury bonds are up, stocks tend to trend down, and vice versa. Considering the above, say you have a portfolio built of nothing but Treasury bonds. Your portfolio would be low risk, but would have limited upside potential. At the same time, Treasury bonds are likely to fall when the market is performing well. Your risk-reward profile in an all-bond portfolio is suboptimal. Under the Modern Portfolio Theory, your portfolio could benefit greatly from a small allocation to high-risk, high-reward equities like small-cap value stocks. These stocks are known for heavy levels of volatility and are significantly riskier than Treasury bonds on an asset-to-asset basis. However, by adding a 10% allocation of small-cap value stocks to a Treasury bond-heavy portfolio, you actually reduce total portfolio risk while increasing your earnings potential. That’s because Treasury bonds will move up and down, but at a slower pace and in a different direction than stocks. When your bond holdings are down, your small-cap value stock holdings will likely pick up the slack and potentially provide substantial gains. On the flip side, when the stocks in the portfolio are down, the Treasury bonds pick up the slack. On the other side of the coin, say you have a portfolio built of 100% stocks. Although your return potential would be relatively high, your risk will also be high. By mixing in a small amount of Treasury bonds, you’ll greatly reduce the risk associated with market volatility while limiting the downward drag on your potential gains.