Since 1952 when modern portfolio theory (MPT) was introduced, it has become one of the most popular investing strategies among financial advisors, investment fund managers and individual investors. MPT formulas demonstrate how the expected return of any given portfolio is the average of the expected returns of the individual assets.
Modern portfolio theory explains how diversification can limit the overall risk for an investment portfolio. MPT allows investors to choose a maximum expected return for a given risk level. Diversification isn’t as simple as buying funds from two separate companies, however. Owning two exchange-traded funds from two companies that are highly correlated (from related industries) can have the same level of risk as owning funds from only one company, according to proponents of modern portfolio theory.
History of Modern Portfolio Theory
American economist Harry Markowitz published his modern portfolio theory in the Journal of Finance in 1952. While Markowitz was not the first person to explore the importance of diversification when investing, his theory was the first to quantify the best method of building an investment portfolio based on a given level of risk. For his efforts — which were quickly adopted and applied by economists and investment professionals — he was awarded Nobel Prize for economics in 1990.
How Does MPT Apply to Investors?
MPT demonstrates how an investor can construct a portfolio that will maximize returns at a given risk level. Risk refers to the degree of uncertain financial loss that is involved in a specific investment. All investments involve some level of risk. In general, investors who buy high-risk stocks are seeking higher returns. As individuals near retirement, for example, they are more likely to seek low-risk investments, such as bonds. It is the job of financial advisors to assess the desired level of risk an investor is willing to take.
A simple example demonstrates how an investor might use MPT insights:
Assume that an individual owns stock in two companies — Company A and Company B. Company A’s stock provides an annual return of 5%, while Company B has an average return of 15%. If the investor is seeking a 10% annual return, he or she would need to invest evenly in both companies. If the investor is seeking a return of 12%, that individual would need to increase the number of Company B shares while lowering the portion of Company A shares. MPT provides specific formulas for making these calculations.
Assets are often grouped into three categories: high risk (options, futures and collectibles), medium risk (mutual funds and stocks) and low risk (government bonds, real estate, CDs and money market accounts).
Learn More About MPT and Other Financial Concepts Through NKU’s Online MBA
The 100% online Master of Business Administration program at Northern Kentucky University teaches the investment strategies needed to apply modern portfolio theory in a real-life setting. As part of the AACSB-accredited program, students choose two of three stacks (12 credit hours) to customize their online MBA. Finance is one such option. The finance stack includes courses on corporate finance, investment and security analysis, and international finance. Each course is taught by esteemed NKU faculty.
Once you have earned your MBA, you will be one step closer to a rewarding career in the financial services sector.
Learn more about NKU’s online MBA program.
Sources:
U.S. News & World Report: What Is Modern Portfolio Theory?
Investopedia: Example of Applying Modern Portfolio Theory (MPT)
Investopedia: Modern Portfolio Theory (MPT)
