Modern Portfolio Theory: Definition, Problem and Solution

Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics.

MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has lower overall risk than any other combination of assets with the same expected return. This is possible, intuitively speaking, because different types of assets sometimes change in value in opposite directions For example, to the extent prices in the stock market move differently from prices in the bond market, a combination of both types of assets can in theory generate lower overall risk than either individually. Diversification can lower risk even if assets' returns are positively correlated.

More technically, MPT models an asset's return as a normally or elliptically distributed random variable, defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets, so that the return of a portfolio is the weighted combination of the assets' returns. By combining different assets whose returns are not perfectly positively correlated, MPT seeks to reduce the total variance of the portfolio return. MPT also assumes that investors are rational and markets are efficient.

MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical modeling of finance. Since then, some theoretical and practical criticisms have been leveled against it. These include evidence that financial returns do not follow a normal distribution or indeed any symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on external events (especially in crises). Further, there remains evidence that investors are not rational and markets may not be efficient. Finally, the low volatility anomaly conflicts with CAPM's trade-off assumption of higher risk for higher return. It states that a portfolio consisting of low volatility equities (like blue chip stocks) reaps higher risk-adjusted returns than a portfolio with high volatility equities (like illiquid penny stocks). A study conducted by Myron Scholes, Michael Jensen, and Fischer Black in 1972 suggests that the relationship between return and beta might be flat or even negatively correlated.

Concept

The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected merely individually, each on its own merits. Rather, it is important to consider how each asset might change in price relative to how every other asset in the portfolio might change in price.

Investing is a tradeoff between risk and expected return. In general, assets with higher expected returns are riskier. The stocks in an efficient portfolio are chosen depending on the investor's risk tolerance: an efficient portfolio is said to be having a combination[clarification needed] of at least two stocks above the minimum variance portfolio. For a given amount of risk, and on a lot of assumptions about the probability distribution of returns on each asset, MPT shows how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the highest-returning available security, of course, unless negative holdings of assets are possible.)

Therefore, MPT is a theory of diversification. Under certain assumptions and for specific quantitative definitions of risk and return, MPT explains how to find the best possible diversification strategy.

Example Problem and Solution: