Meaning of Modern Portfolio Theory
Modern portfolio theory (MPT) is a theory that is used by investors for constructing an ideal portfolio of assets. It is an investment strategy that argues that a portfolio with a higher level of expected return can be created by considering the optimum amount of risk. Modern portfolio theory is the well-known investment-related strategy developed by an economist named ‘Harry Markowitz’ in the year 1950. It is also termed as mean-variance analysis having a mathematical framework for assembling of high-performing assets portfolio for investors. The theory believes that investors are risk-averse who would always like to have a less risky portfolio for a given amount of risk.
MPT majorly utilizes the diversification strategy of investment in order to bring down the associated level of risk. Assets are included from different classes into portfolios instead of holding all ideal ones together. The theory says that markets are efficient and reliable, therefore spreading of investment across distinct assets can yield a higher amount of returns. Every investor wants to earn higher value returns in long run without taking much market risk in short term. However, the risk and return are positively co-related such that for every amount of return there is always a risk associated with it. MPT is of great importance for average investors having lack time or knowledge to build an efficient balanced portfolio.
Features of Modern Portfolio Theory
Various features of modern portfolio theory are as discussed in the points given below: –
Creation of balanced portfolio
Modern portfolio theory provides large benefits to investors via the creation of the ideal and balanced portfolio. Investors may lack the knowledge to identify and construct an ideal portfolio themselves. Under these circumstances, amateur investors can utilize MBT theory to come up with a profitable portfolio.
Bring down the risk amount
This theory analyzes market securities efficiently for decreasing the amount of risk in investment. Modern portfolio theory employs a diversification strategy and spreads investment among the variety of assets/securities. A portfolio of co-related assets is avoided so that if any of the assets leads to losses, then it does not have any major negative influence over the whole portfolio held by the investor. Spreading of investment among diversified assets reduces the risk fluctuations in investment.
Identification of risky/underperforming assets
Modern portfolio theory performs an in-depth analysis of securities while creating a well-balanced portfolio. The analysis helps in the easy identification of underperforming or risky assets so that they can be replaced with efficient ones.
Guide investors in building value
MBT theory guides an average investor having a lack of knowledge as well as time to perform analysis of securities to great extent. Risk-averse investors can utilize it to identify high-risk assets which can be avoided for building a balanced portfolio. This way it assists investors in earning a higher amount of return with a small amount of risk associated.
Assumptions of Modern Portfolio Theory
Modern portfolio theory carries different assumptions which need to be considered while arriving at a final decision. These assumptions are as follows: –
Investors aim to maximize returns
Maximization of returns by investors is a valid assumption on which modern portfolio theory rests. Every investor wants to earn high returns with low risk in the short run. Like, if there are 2 sets of assets each one carrying a 7% of risk then as per MBT, the investor would go for an asset that carries low risk out of these two.
Investors are rational and risk-averse
This is another major assumption carried out by modern portfolio theory. The investor always tries to avoid risk as much as possible and prefers taking a low amount of risk. Following from the first assumption, now suppose if there are two securities carrying a constant rate of return then the investor would go for security that has low risk associated with it. Investors at every point of time try to minimize their risk and maximize their return.
Investors are aware of risk and return about each investment
It is an unrealistic assumption on which MBT theory relies while arriving at conclusion. MBT theory assumes that investors know risk and return on every investment. This can be valid in a finance class where all variables are given. Whereas, in a realistic world, this can be complex where investors majorly base their investment decision on expected return and risk. There are no other considerations which are further taken into consideration while taking decision by them.
Every investor has access to the same information
MBT assumes that all investors have access to the same amount of information for making different computations. Each one of them utilizes the same information for drawing inferences from it. This assumption comes from an efficient market hypothesis but in the real market, it is quite impractical. The real market in fact consists of information asymmetry and there are incidents of insider trading, where one is more informed than the other.
Asset returns are normally distributed
MBT relies on assumption that all assets carry a normally distributed return. In real life, returns of equity and other markets are not distributed normally. Many times there are large swings that occur in the market more frequently as compared to what a normal distribution assumption predicts.
Tax and transaction cost is not considered
MBT does not take into consideration the taxation and transaction cost while making decisions. In the real world, financial products are subject to both taxes as well as transaction cost i.e., broker fees.
Advantages of Modern Portfolio Theory
The advantages of modern portfolio theory are as follows: –
Manage and evaluate risk as well as return
MBT serves as a great tool in managing the overall risk and return involved in investment decisions. It carries out an in-depth analysis of securities for finding out which ones are underperforming. These non-efficient and high-risk carrying assets are then replaced with good performing assets which enables avoiding the market risk. In this way, investors are easily able to construct a balanced portfolio of assets thereby offering them higher returns.
Avoid financial ruin
This theory enables traders in avoiding the financial ruin arising from market volatility. MBT theory believes in doing investment in distinct or non-correlated assets instead of similar ones. When a portfolio is composed of diversified assets, then investors have more probability of getting higher returns at lower risk.
MPT is of great importance if an investor is looking to build a diversified portfolio. Investors can easily have access to different asset classes via utilizing the modern portfolio theory. This theory can help them in lowering their risk level by investing a very small amount in government bond ETFs.
Disadvantages of Modern Portfolio Theory
Various disadvantages of MBT are summarized in the following points below: –
Considers past performance of the company
The major drawback of MBT is that it considers the past performance of a company whose securities are being analyzed for investment decisions. However, the company’s past performance cannot guarantee the future state of operations. Relying majorly on historical data can overpass the newer circumstances thereby leading to wrong decisions.
Security of any size can be bought and sold
Modern portfolio theory believes that any size security can be brought and sold. But in real life, this does not hold true as many securities carry a minimum order size and can’t be dealt with infractions.
Assumes normal distribution of return
There is an assumption in MBT regarding the normal distribution of return on an asset within the class of assets. In the case of individual equities, the following assumption proved to be wrong where asset class correlation may vary over a period of time.
Criticism by behavioural economists
Modern portfolio theory has received a lot of criticism although it is majorly used all around the world by distinct investment institutions. The behavioral economic representatives have criticized and challenged this theory because of its invalid assumptions. The MBT assumptions are criticized on the basis of parameters involving returns expectations and the rationality of investors.