Modern Portfolio Theory (MPT)
Candlefocus EditorThe primary benefit of modern portfolio theory is that it advocates a long-term and objective method to construct an optimal mix of assets in a portfolio. Instead of relying on intuition or the subjective opinion of the investor and making irrational decisions, MPT uses extremely sophisticated mathematical models to create an allocation of assets.
Using the modern portfolio theory, an investor can combine assets from the same asset class, like stocks and bonds, or from different asset classes, such as stocks and commodities. By doing this, the investor can create a well-diversified portfolio with a better risk-to-return ratio. MPT also takes into account that investments with higher returns also tend to come with more risk and therefore tries to find the optimal balance between risk and return.
MPT also provides investors with insight on portfolio optimization and convexity. With portfolio optimization, investors can minimize risk by portfolio diversification and optimal asset allocations. Convexity is a risk management tool in which investments are leveled off according to their risks; the higher the risk, the further the asset should be to the center of the risk profile. This also helps investors increase their return-on-investment.
Inspite of considerable advancements in the application of MPT, some experts in the investment industry are now looking to the next level –“Post-Modern Portfolio Theory” (PMPT) which account for the imperfections of the markets and tries to address limitations of the MPT. PMPT looks at portfolio construction from a different perspective - it involves higher order asset classes such as real estate, commodities and derivatives and takes into account behaviors of market participants, such as human emotions, trade-out cycles and market over- and under-reactions to external news. It also allows for more risk factors like contagion, liquidity and skewness.
Overall, modern portfolio theory is a valuable tool for investors to construct balanced and diversified portfolios that seek to maximize returns and minimize risk. The PMPT, with its additional components, further adds sophistication and sophistication and is especially useful to investors looking to strike a balance between short-term risks and long-term rewards.