4 key principles of Modern Portfolio Theory

NNatalie October 2, 2023 10:46 PM

The Modern Portfolio Theory (MPT), brought to light by economist Harry Markowitz in the 1950s, has become a significant cornerstone in finance and investment strategies. It highlights an effective approach to assembling a portfolio of assets so that the expected return is maximized for a given level of risk. Let's explore the four key principles of Modern Portfolio Theory that to this day, guide investors worldwide.

Diversification

The first principle, Diversification, is perhaps one of the most widely known concepts in investing. It is the strategy of spreading investments across various assets to reduce exposure to any one particular asset. The theory argues that a diversified portfolio will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Investors can achieve diversification by investing in a mix of stocks, bonds, real estate, and other asset classes. This creates a balanced portfolio that can withstand market volatility and reduce potential losses.

Risk and return

The second principle of MPT is the concept of Risk and Return. It suggests that higher risk is associated with greater probability of higher return and lower risk with a lower return. This is known as the risk-return tradeoff.

In practical terms, if an investment seems too good to be true, it probably is. High returns are often an indication of high risk. Hence, investors must carefully consider their risk tolerance when choosing their investments.

Asset allocation

The third principle, Asset Allocation, involves dividing an investment portfolio among different asset categories. The most common categories include stocks, bonds, and cash or cash equivalents.

The purpose of asset allocation is to provide the investor with a risk level that is acceptable to them. Each asset class has a different level of risk and return, so each will behave differently over time. An investor's ideal mix of assets must be constructed based upon their investment goals, risk tolerance, and investment horizon.

Efficient frontier

The last principle, the Efficient Frontier, represents the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal.

The Efficient Frontier is a crucial part of the Modern Portfolio Theory as it gives a visual representation of the risk/return trade-off for a specific portfolio.

Let's summarize these principles in a table below:

Principle Description
Diversification Spreading investments across various assets to reduce exposure to any one particular asset.
Risk and return Higher risk is associated with greater probability of higher return and vice versa.
Asset allocation Dividing an investment portfolio among different asset categories based on investment goals, risk tolerance, and investment horizon.
Efficient frontier Represents optimal portfolios offering the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.

These principles provide a roadmap for investors to build and manage their portfolios. Remember, the ultimate goal of investing is not to make money quickly but to grow wealth sustainably over time.

More articles

Also read

Here are some interesting articles on other sites from our network.