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Modern Portfolio Theory Definition
Modern Portfolio Theory (MPT) is an investing model based upon the level of market risk and expected return. The model is applied to a group of investments making up an investor’s complete portfolio. The objective is to hold a combination of diverse assets (diversification) that minimize risk and maximize potential return. The theory relies on the precept that investors are risk-averse and will only accept the greater risk if there is a possibility of greater return.
A Little More on What is Modern Portfolio Theory
Modern Portfolio Theory asserts that the risk associated with holding individual investments can be mitigated by combining assets (such as cash, stocks, bonds, derivatives, and alternative assets) into a diverse portfolio. These assets will be combined based upon how they react to market forces. Financial analysts will apply variance and correlation tests for each asset in the portfolio based upon historical performance to make these determinations. By identifying how the assets will react with each other, it is possible to minimize the risk associated with each individual holding.
Further, the approach can maximize returns by achieving a mix of holdings along the efficient frontier – which entails the maximum potential return for a given level of risk. This makes it possible to evaluate the risk and potential return of individual assets based upon its effect on the entire portfolio – as each asset may perform uniquely based upon market conditions.
References for Modern Portfolio Theory
Academic Research on Modern Portfolio Theory (MPT)
Modern portfolio theory, 1950 to date, Elton, E. J., & Gruber, M. J. (1997). Modern portfolio theory, 1950 to date. Journal of Banking & Finance, 21(11-12), 1743-1759. This article reviews “Modern Portfolio Analysis” and outlined some important topics for further research. Issues discussed include the history and future of portfolio theory, the key inputs necessary to perform portfolio optimization, specific problems in applying portfolio theory to financial institutions, and the methods for evaluating how well portfolios are managed.
Extending modern portfolio theory into the domain of corporate diversification: Does it apply?, Lubatkin, M., & Chatterjee, S. (1994). Extending modern portfolio theory into the domain of corporate diversification: Does it apply?. Academy of Management Journal, 37(1), 109-136. In this paper, the authors test the notion that diversification lowers a firm’s unsystematic (business-specific) risk, but does not affect its specific (systemwide) risks. This paper aims to show that an important way for corporations to minimize risk is to diversify into similar businesses rather than into identical or very different businesses.
The legacy of modern portfolio theory, Fabozzi, F. J., Gupta, F., & Markowitz, H. M. (2002). The legacy of modern portfolio theory. Journal of Investing, 11(3), 7-22. In this article the authors briefly explain the Modern Portfolio Theory (MPT) underlying MPT and using illustrations highlight the application of MPT to the current practice of asset management and portfolio construction. The authors also survey most of the relevant research that has directly or indirectly been either an outcome of MPT or has contributed to the implementation of MPT.
Post-modern portfolio theory comes of age, Rom, B. M., & Ferguson, K. W. (1994). Post-modern portfolio theory comes of age. Journal of Investing, 3(3), 11-17. This paper provides a brief history and the idea behind Harry Markowitz’s creation of the Modern Portfolio Theory (MPT).
British investment overseas 1870–1913: a modern portfolio theory approach, Goetzmann, W. N., & Ukhov, A. D. (2006). British investment overseas 1870–1913: a modern portfolio theory approach. Review of Finance, 10(2), 261-300. This study uses a mean-variance approach to address the classic puzzle of British capital export in the 19th century. The analysis shows that foreign securities listed in London offered significant diversification benefits to British investors.
Toward the design of better equity benchmarks: Rehabilitating the tangency portfolio from modern portfolio theory, Martellini, L. (2008). Toward the design of better equity benchmarks: Rehabilitating the tangency portfolio from modern portfolio theory. Journal of Portfolio Management, 34(4), 34. Following recent research on the relevance of idiosyncratic risk in asset pricing models, the author proposes using total volatility as a model-free estimate of a stock’s excess expected return and analyzes the implications, in terms of design, for improved equity benchmarks. The author finds that maximum Sharpe ratio portfolios are consistent with such expected return proxies and, if built upon improved estimates of the correlation parameters, will significantly outperform market cap–weighted schemes on a risk-adjusted basis. The article has important potential implications for the on-going debate about appropriate weighting schemes for equity indices.
Modern Portfolio Theory and Investment Management Law: Refinement of Legal Doctrine, Bines, H. E. (1976). Modern Portfolio Theory and Investment Management Law: Refinement of Legal Doctrine. Colum. L. Rev., 76, 721.
The modern portfolio theory as an investment decision tool, Omisore, I., Yusuf, M., & Christopher, N. (2011). The modern portfolio theory as an investment decision tool. Journal of Accounting and Taxation, 4(2), 19-28.
Modern portfolio theory and behavioral finance, Curtis, G. (2004). Modern portfolio theory and behavioral finance. The Journal of Wealth Management, 7(2), 16-22.The author starts with a brief history of the ‘discoveries’ of modern portfolio theory and behavioral finance and suggests that the latter may well create just as much of a revolution in the wealth management world as the former did in institutional asset management. The author also identifies seven potential areas of weakness that can vitiate outcomes of behavioural finance.
The new prudent investor rule and the modern portfolio theory: A new direction for fiduciaries, Aalberts, R. J., & Poon, P. S. (1996). The new prudent investor rule and the modern portfolio theory: A new direction for fiduciaries. American Business Law Journal, 34(1), 39-72.