Updated: Oct 22, 2021
Modern Portfolio Theory
Modern portfolio theory (MPT) is an investing strategy designed to help investors minimize market risk while maximizing returns. It is based on the assumption that markets are efficient and use diversification to spread investments across various assets.
How Does Modern Portfolio Theory Work?
Modern portfolio theory believes that every investor wants to get the highest possible long-term returns without taking severe short-term market risk levels. Reward and risk in investing are linked positively, so you can expect lower returns if you have low-risk investments, such as cash or bonds.
On the other hand, to get higher returns, you'll need to invest in more volatile and riskier investments like stocks. But, you might not be comfortable putting your money into those investments if your comfort levels don't align with the level of risk.
MPT's solution to this dilemma is through diversification, where you spread your money across various investments and asset classes. MPT suggests an investor hold a specific investment or asset type that is individually high in risk. But, when combined with other types, there's a balance in the portfolio where risk is lower than the individual risk of investments or underlying assets.
An investor will essentially buy a mixture of both risky stocks and low-return bonds to ensure they get a maximum possible return over the long run.
According to MPT, your goal shouldn't be to get the highest returns from the highest risk when selecting investments. Instead, your portfolio should balance risk and reward by getting the highest return at acceptable levels of risk.
Pros of Modern Portfolio Theory
· It's suitable for the average investor: An average investor can get a balanced portfolio by applying MPT os using its key ideas.
· No timing in the market: Most investors don't have the knowledge, time, or emotional distance to maximize their returns for minimal risk.
· It decreases the risk in investing: There's protection from market changes when you spread your investments across assets that aren't positively linked.
Cons of Modern Portfolio Theory
· Standardized assumptions: MPT functions get based on a standardized set of market behavior assumptions. These assumptions may not carry out in a financial climate that's constantly changing.
· MPTs aren't based on modern data: The concepts of correlation, risk, and reward underlying MPT are drawn from historical data. The data may not apply to the market's new circumstances.
The Bottom Line
Modern portfolio theories can get used for portfolio diversification. A diverse set of integrated assets can reduce its variance and reduce volatility.
Modern portfolio theory can help create the most efficient portfolio possible. Finding efficiency in returns is vital for companies with similar returns, so you need to ensure you do your research before following any investment strategy.
A wealth manager understands the various investment strategies and can create a suitable individual strategy to suit the needs of investors. To find out how SK Capital can help you with your investment strategy and diversify your portfolio, you can contact us for a free consultation.