What is Modern Portfolio Theory (MPT)?
Modern portfolio theory (MPT) is a body of mathematical and financial analysis that seeks to understand the efficient allocation of risk and capital in securities portfolios.
MPT is based on the premise that investors can achieve superior returns by diversifying their investments across a range of asset classes rather than holding a single security or investment for an extended period of time.
Modern portfolio theory was developed in the 1970s to help investors make better decisions when investing in stocks, bonds, and other securities. The application of MPT has helped people to improve portfolio performance over the past several decades.
How Does Modern Portfolio Theory Work?
As an old adage goes, there are two ways to make money in the stock market: timing the market and time in the market. The former seeks to maximize returns by capitalizing on changes in the prices of equities, and the latter seeks to capitalize on the tendency of the stock market to increase in value over time.
MPT dictates that by minimizing risk and investing with a long time horizon, investors can maximize their returns. Furthermore, MPT adherents avoid the unnecessary risk of attempting to time an unpredictable market. From this perspective, risk is broken into two broad categories—systematic and unsystematic risk.
Systematic vs. Unsystematic Risk
Not all risk is created equal. Systematic risks are caused by factors outside the control of investors. Market volatility, for example, produces risk that can impact returns, but no single investor can eliminate this level of risk.
Unsystematic risks are those that are produced from investor activity (such as attempting to time the market), the business activities of individual companies, and other sources such as favorable or unfavorable industry news. While it is true that an individual investor likely can’t control the outcome of these events, their impact on returns at the portfolio level can be mitigated by “spreading the risk around,” or increasing the level of diversification in a portfolio.
Managing Systematic Risk
Some element of systematic risk is unavoidable—no investment activity can be made entirely riskless. Market events, geopolitical factors, acts of God, and the like will continue to impact the stock market despite anyone’s best efforts to intervene.
There are, however, ways to reduce the impact of systematic risks on your portfolio. First, a policy of portfolio diversification can help keep systematic risk at a minimum. Systematic risk is not evenly distributed across all market sectors; an external event that causes a market sell-off may have a muted effect on countercyclical stocks, for example. A diversified portfolio spreads systematic risk across various sectors, meaning a drop in one area won’t wipe out gains across the entire portfolio.
A second method of minimizing systematic risk is to invest in index funds. Index funds are those that select their constituent securities based on an index or list of publicly traded companies that meet certain criteria. This is an easy way to buy into a basket of companies based on an investing thesis without having to research each and every company that meets your investing criteria.
Managing Unsystematic Risk
A set-it-and-forget-it mindset is the best way to combat unsystematic risk. Trying to time the market, buying and selling based on news or investor sentiment, and loading your portfolio with securities from one market sector creates unnecessary unsystematic risk. Putting all your eggs in one basket by only buying shares in a single equity concentrates all your exposure to risk on the business operations and investor sentiment of just a single company.
The Benefits and Drawbacks of Diversified Portfolios
Modern portfolio theory came about as a way to maximize returns for the long term. A diverse portfolio is one that is resilient to risk and can absorb the shocks of market swings. The diversified portfolio that MPT preaches is a good way to realize gains while keeping risks to a minimum.
This safe, slow, and steady accumulation has been demonstrated to be reliable, but it doesn’t conform to every investing objective.
Diversified portfolios spread risk around, but this means that they also spread around returns. Concentrating holdings in a specific market sector or with a small group of similar securities increases unsystematic risk, but it also increases potential returns.
While it goes against prevailing financial wisdom, some investors are more interested in taking larger risks with their capital.
The Bottom Line
A portfolio designed around the modern portfolio approach of minimizing systematic and unsystematic risk won’t produce eye-popping returns, but it is currently the most sophisticated method available for creating a portfolio that can withstand market risk while still providing returns.