For serious investors aiming to build a strong portfolio, it’s crucial to grasp the Modern Portfolio Theory (MPT). This theory makes it easier to handle risks and returns, becoming a key tool for successful investing. Let’s explore this financial idea in this simple, how-to guide.
The Relevance of Modern Portfolio Theory
Exploring stock market theories is a great way to grasp how the financial world works. These theories provide insights that make navigating the uncertain investment landscape more understandable and predictable.
Various theories like Dow Theory, Efficient Market Hypothesis (EMH), and Capital Asset Pricing Model (CAPM) help analyze market behavior, but Modern Portfolio Theory stands out for its unique approach to handling risk.
For beginners, risk in investing means the leftover worry after considering all possible negative scenarios. For more experienced investors, it’s simply a deviation from the expected mean or average.
This guide simplifies understanding of Modern Portfolio Theory (MPT) to effectively manage potential risks stemming from the nature of assets and the market.
Wall Street Whims to Scientific Investing- The Birth of MPT
MPT, or Modern Portfolio Theory, aims to help investors maximize returns while managing risk. Introduced by economist Harry Markowitz, it suggests building a portfolio that balances potential returns and risk. Markowitz’s idea was to create a diverse portfolio, reducing risk by spreading investments. This way, if some assets drop, others can compensate.
Markowitz believed most investors prefer less risk, even if it means lower returns. His theory suggests selecting a portfolio that offers the highest possible return with the least risk. Published in 1952, his work highlighted the importance of diversification and efficient portfolio selection.
In essence, MPT guides investors to choose assets based on how they interact in the portfolio, emphasizing the impact on overall value.
Why Modern Portfolio Theory (MPT) Matters
When your financial adviser or you decide to create a “diversified portfolio” by allocating different percentages to various assets like stocks, commodities, and fixed income, that’s Modern Portfolio Theory in action.
Managing your own investments, whether it’s mutual funds or specific securities in your NPS, involves understanding how to allocate your investments and calculate risks. Many advisers and fund managers do this work for you, making it obscured from your vision.
For instance, when investing in government-provided funds like NPS in India, the portfolio manager provides information on past returns and market comparisons to help you decide where to allocate your investments.
A good financial adviser will ask about your “risk profile,” assessing how much risk you’re willing to take for a potential return. Younger investors can usually handle more risk, while older individuals with fixed incomes may have lower risk tolerance due to less time for recovery from downturns.
A Deeper Dive into Modern Portfolio Theory
In simple terms, Modern Portfolio Theory (MPT) is a way to decide how to distribute your money among different investments. Imagine you have ₹1 crore in your investment portfolio, with ₹80 lakh in one asset and ₹20 lakh in another.
Let’s say you want a 5% return on the ₹80 lakh and a 10% return on the ₹20 lakh. To figure out your overall expected return, you calculate a weighted average.
For the ₹80 lakh investment: 80% of the portfolio, 5% return.
For the ₹20 lakh investment: 20% of the portfolio, 10% return.
Adding them up, your overall portfolio can expect a 6% return. If you want to aim for a 7.5% return, you might shift some money from the 5% return investment to the 10% return one.
In this next example, a 50-50 split achieves that.
- Portfolio Expected Return of 7.5% = 50% x 5% = 2.5%
- Plus 50% x 10% = 5%
- Portfolio Expected Return = 2.5% + 5% = 7.5%
- Composite Portfolio Expected Return of 7.5%
The same can be true if the investor of the same ₹1 crore portfolio wants to increase or reduce risk in the portfolio.
Beta in Action- How It Impacts Your Portfolio Selection
Modern Portfolio Theory introduces a measure called beta, which gauges how much risk your investments have compared to the overall market. A beta of 1 means your risk aligns with the market. Higher betas mean more risk, and lower betas mean less.
Imagine you have ₹1 crore split equally among four assets. Each asset has a different beta reflecting its risk. To calculate the overall risk of your portfolio, you multiply the allocation percentage of each asset by its beta.
If you want more risk for potentially higher returns, you can adjust the allocations. For example, by shifting some money from safer assets to riskier ones, you can reach a desired beta.
In the situation, we are about to explore, investing more in the asset with a higher beta achieves a portfolio beta close to the desired level of 1.2.
Building a Diversified Portfolio– Putting MPT into Practice
Let’s break down the calculations step by step for a better understanding.
Step 1. Initial Portfolio Composition (Equal Allocation)
- Asset 1 (Beta = 1): 25% of ₹1 crore = ₹25 lakh
- Asset 2 (Beta = 1.6): 25% of ₹1 crore = ₹25 lakh
- Asset 3 (Beta = 0.75): 25% of ₹1 crore = ₹25 lakh
- Asset 4 (Beta = 0.5): 25% of ₹1 crore = ₹25 lakh
Step 2. Calculate the Beta for Each Asset
- Asset 1 Beta Contribution = 25% * 1 = 0.25
- Asset 2 Beta Contribution = 25% * 1.6 = 0.4
- Asset 3 Beta Contribution = 25% * 0.75 = 0.1875
- Asset 4 Beta Contribution = 25% * 0.5 = 0.125
Step 3. Calculate Initial Portfolio Beta
Overall Portfolio Beta = 0.25 + 0.4 + 0.1875 + 0.125 = 0.9625
At this point, the portfolio beta is 0.9625, close to but slightly below the desired 1.2.
Step 4. Adjusting Portfolio for Higher Beta
- Increase allocation to Asset 2 (higher beta) and reduce allocations to Assets 3 and 4.
- Suppose you shift 10% from Assets 3 and 4 and 5% from Asset 1 to Asset 2.
Step 5. Updated Portfolio Composition
- Asset 1: 20% (₹20 lakh)
- Asset 2: 50% (₹50 lakh)
- Asset 3: 15% (₹15 lakh)
- Asset 4: 15% (₹15 lakh)
Step 6. Calculate New Beta Contributions
- Asset 1 Beta Contribution = 20% * 1 = 0.2
- Asset 2 Beta Contribution = 50% * 1.6 = 0.8
- Asset 3 Beta Contribution = 15% * 0.75 = 0.1125
- Asset 4 Beta Contribution = 15% * 0.5 = 0.075
Step 7. Calculate Updated Portfolio Beta
Overall Portfolio Beta = 0.2 + 0.8 + 0.1125 + 0.075 = 1.1875
The new portfolio beta is 1.1875, very close to the desired 1.2. Adjusting the allocations as described achieves the targeted level of systematic risk.
Beyond the Books- Real-World Challenges of MPT
Many experts argue that Modern Portfolio Theory (MPT) isn’t practical for the real world because it relies on projected values and mathematical expectations rather than actual, current data. MPT uses historical measurements of asset returns and volatility, making it vulnerable to changes from unknown variables not considered when making predictions.
The model estimates risk by looking at the likelihood of losses without explaining why those losses might happen. This makes risk assessment more like a probability calculation than a structural understanding of the market.
In simpler terms, MPT makes investing seem organized in its math, but in reality, the unpredictable nature of the market makes it less straightforward.
We trust that now you understand the basics of Modern Portfolio Theory. Feel free to explore this approach to investing, but always remember the importance of adapting to the unpredictable nature of the financial landscape.
Frequently Asked Questions (FAQs)
1. What is Modern Portfolio Theory (MPT)?
Modern Portfolio Theory (MPT) is a financial concept introduced by economist Harry Markowitz in 1952. It guides investors in building portfolios that balance potential returns and risks through diversification.
2. How does MPT help manage risk?
MPT suggests creating a diverse portfolio and spreading investments to reduce risk. By selecting assets that interact effectively, it aims to achieve the highest possible return with the least risk.
3. Why is diversification important in MPT?
Diversification, a key principle of MPT, involves spreading investments across different assets. This helps minimize the impact of poor-performing assets on the overall portfolio.
4. How can MPT be applied practically?
Investors apply MPT by allocating percentages to various assets based on their risk profile and desired returns. This process involves assessing individual assets’ betas and adjusting allocations accordingly.
5. What are the limitations of MPT?
Critics argue that MPT relies on historical data, making it vulnerable to unforeseen changes. The model estimates risk based on past measurements, which may not account for all variables in the unpredictable nature of the market.
