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Signed in but can't access contentOxford Academic is home to a wide variety of products. The institutional subscription may not cover the content that you are trying to access. If you believe you should have access to that content, please contact your librarian. Institutional account managementFor librarians and administrators, your personal account also provides access to institutional account management. Here you will find options to view and activate subscriptions, manage institutional settings and access options, access usage statistics, and more. Definition and Example of Modern Portfolio TheoryDeveloped by Nobel Laureate Harry Markowitz, modern portfolio theory is a widely used model. It's meant to help investors minimize market risk. At the same time, it can maximize their returns. MPT is a theory based on the premise that markets are efficient and more reliable than investors. You can use MPT to choose the investments in your portfolio. MPT most often promotes a buy-and-hold strategy with occasional rebalancing.
Investing in growth stocks may carry a higher risk of loss when compared to the overall market. As a result, a portfolio might have a portion allocated to bonds. If the stock market and growth stocks decline, the bond investments would still earn interest and experience less volatility, offsetting, in part, the market risk of the equity portion of the portfolio. Another example involves investing in assets whose prices are
negatively correlated, meaning their prices tend to move in the opposite direction. Oil prices and airline stock prices tend to move in the opposite direction. Since airlines use oil as fuel, a rise in oil prices leads to higher costs and lower airline stock prices. Conversely, when oil prices decline, so too do airline fuel costs, leading to higher airline stock prices. How Modern Portfolio Theory WorksModern portfolio theory assumes that every investor wants to achieve the highest possible long-term returns without taking extreme levels of short-term market risk. Risk and reward are positively correlated in investing; if you opt for low-risk investments, such as bonds or cash, you can expect lower returns. You'll need to invest in investments with more risk, like stocks, to receive higher returns. You might not be willing to take the gamble and put your money into those investments, though. It depends on your comfort level with risk. The way to overcome this, according to MPT, is through diversification. This theory promotes the spread of money across different asset classes and investments. MPT says you can hold a certain asset type or investment that is high in risk, but when you combine it with others of different types, the whole portfolio can be balanced. Then its risk is lower than the individual risk of underlying assets or investments. For instance, you wouldn't hold only risky stocks or only low-return bonds. Instead, you would buy and hold a mixture of both to ensure the largest possible return over time. NoteOne simple way to remember MPT is that "the whole is greater than the sum of its parts." Risky individual investments do not have to make for a risky portfolio overall. Types of MPT StrategiesWhen choosing investments, your goal shouldn't be to accept the highest risk to extract the highest returns. Instead, your portfolio should be on what Markowitz called the "efficient frontier." This means it should balance risk and reward so that you get the highest return at an acceptable level of risk. There are a few ways to achieve this goal. Strategic Asset AllocationThe simplest way to create an efficient portfolio is through a strategic, or passive approach. This is where you buy and hold combinations of assets and investments that aren't positively correlated. In other words, they don't move up and down under the same market conditions. You include these in your portfolio in fixed percentages. For instance, as an asset class, stocks are often higher in market risk than bonds. A portfolio consisting of both stocks and bonds may achieve a reasonable return for a relatively lower level of risk. Stocks and bonds are negatively correlated. As stocks go up in price, bonds tend to go down in price. MPT strategy further minimizes substantial losses in your overall portfolio value when one asset class declines. On the investment level, foreign stocks and small-cap stocks are often higher in risk than large-cap stocks. MPT allows you to combine all three. You can potentially achieve above-average returns compared to a benchmark such as the S&P 500, all for an average level of risk. One investment selection governed by MPT might be a portfolio of mutual funds containing:
Even with a strategic asset allocation approach, it's important to rebalance your portfolio or bring it back to its original asset allocation periodically. That helps you avoid overweighting certain assets and keep your holdings in sync with your investment goals. Two-Fund TheoremYou don't need a complex portfolio made up of many investments to comply with MPT. The theory states that you can achieve an efficient portfolio with only two mutual funds. This approach allows you to avoid picking any individual stocks. This approach might create a two-fund portfolio divided equally between stocks and bonds:
NoteSuppose you had a portfolio equally split between stocks and bonds. Between 1970 and 2003, it would have produced similar returns at a lower level of volatility and greater diversification than either asset class alone. Pros and Cons of MPTPros
Cons
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Alternatives to MPTYou may feel that knowledge of behavior and price volatility in the market will allow you to make more timely investment decisions. If you are uncomfortable with the buy-and-hold nature of MPT, a tactical asset allocation approach may be an option. With tactical asset allocation, you can still incorporate the three primary asset classes (stocks, bonds, and cash) into your portfolio. But unlike investors who use MPT, you would then actively balance and adjust the weights (percentages) of the assets. You would do that by using technicaland fundamental analysis to maximize portfolio returns and minimize risk compared to a benchmark. You may find that a combination of the two approaches is the best strategy. For instance, you may often buy and hold assets according to MPT, but you still might take advantage of changes in the market. Perhaps you buy more stocks during a recession, when they are lower in price. You would then hold those assets for a long time; that would allow them to return to their pre-recession levels and increase the value of your portfolio. You also may form opinions about some sectors in the economy, such as the technology or travel & hospitality industries, and select your favorite stocks in them for a tactical investing layer added on top of a passive long-term MPT strategy. Key Takeaways
What is the concept of portfolio theory?The Modern Portfolio Theory (MPT) refers to an investment theory that allows investors to assemble an asset portfolio that maximizes expected return for a given level of risk. The theory assumes that investors are risk-averse; for a given level of expected return, investors will always prefer the less risky portfolio.
Which is included in modern concept of portfolio analysis?The modern portfolio theory (MPT) is a practical method for selecting investments in order to maximize their overall returns within an acceptable level of risk. A key component of the MPT theory is diversification. Most investments are either high risk and high return or low risk and low return.
What are the 2 key ideas of modern portfolio theory?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 ...
Which of the following are assumptions of modern portfolio theory?Assumptions of Modern Portfolio Theory
Returns from the assets are distributed normally. The investor making the investment is rational and will avoid all the unnecessary risk associated. Investors will give their best in order to maximize returns for all the unique situations provided.
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