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Modern Portfolio Theory (MPT) is an investment theory introduced by Harry Markowitz in 1952. It says that an investor can create a portfolio that optimizes their returns based on a certain level of market risk.
You’ve probably heard the bottom line before: more risk brings more rewards. A diversified portfolio with assets unrelated to one another is also an important point in MPT.
MPT, sometimes just referred to as portfolio theory or portfolio management theory, is one of the most pivotal theories related to economics and investment.
On this page:
- What is Modern Portfolio Theory?
- What Modern Portfolio Theory Means for You
- How to Use Modern Portfolio Theory
What is Modern Portfolio Theory?
Every investor should be mindful of Modern Portfolio Theory and its role in creating an optimized portfolio. Here are some of the key elements of MPT:
- Risk is defined as the range in how much the price of an asset varies on average, or the standard deviation.
- The risk of a diversified investment portfolio is less than the risk of holding stock in one company — as long as the risks of the stocks in the diversified portfolio aren’t directly related.
- If two assets are similar or are moved by similar effects or events, then their prices will move similarly. With that in mind, a diversified portfolio should ideally not have assets that are correlated.
- The more unique the assets or stocks an investor owns, the lower the risk for the overall portfolio.
Understanding MPT and What It Means for You
MPT is important for all investors, especially long-term investors. It helps take the emotion out of decision making in investing. Instead, it’s based on a mathematical framework. So, investors can think more strategically rather than reacting emotionally to stock moves.
Basing a portfolio on MPT is one of the best approaches for the long-term investor. It can help improve discipline and returns.
Modern Portfolio Theory helps investors prepare for retirement. By understanding that taking on risk can bring more rewards, younger investors often take on more risk because their portfolios have time to recoup from losses.
But older investors, who do not want to take on risk and lose their hard-earned investments, can invest in less risky stocks and anticipate steady but smaller returns, such as through bonds or blue-chip stocks.
>> Read More: How to Start Investing
How Advisors Use Modern Portfolio Theory
Most investment advisors and robo-advisors rely on the foundation of modern portfolio theory. With robo-advisors, users select their personal objectives and risk tolerance and then advanced algorithms design asset allocations.
How to Use MPT to Your Advantage
Many younger investors opt for riskier portfolios. This is because they have more earning years and a longer time period until they retire. This gives their portfolios more time to weather any losses. When you’re younger, you’re likely going to invest in more stocks because they are inherently riskier than other investment vehicles.
Stocks tend to offer higher returns than bonds. At they same time, they suffer more ups and downs, so there may be serious losses along the way. Still, under MPT, these portfolios are likely going to see higher returns longterm.
However, as you get older and closer to retirement, it’s more difficult to weather a serious event in the markets, like the financial crisis of 2008. If you’re close to retirement or near retirement, recessions can be a crippling blow to your investments.
As someone gets closer to retirement, they’re typically going to move away from a portfolio that’s predominantly made up of stocks. Instead, they may be more likely to start including more bonds, which are less risky. People nearing retirement, tend to move from a portfolio that aims for growth to one that aims for steady returns and reliable income.
When you’re planning an investment portfolio, one of the most important considerations is your age and when you expect to retire. This helps you determine the level of risk you can tolerate and the kinds of assets you should invest in.
Modern portfolio theory doesn’t guarantee returns but explains how risk and reward are related. It provides a solid foundation on how to minimize risk when investing.
A lot of what you learn from market analysts and portfolio managers is based on modern portfolio theory.
Modern portfolio theory isn’t, however, used by day traders or anyone who wants to take a highly risky strategy, since it’s not built on the idea of investing in single stocks.
Modern portfolio theory can be extremely valuable for investors of any age who are developing a strategy for their portfolio.
Author: Ashley Sutphin