Modern Portfolio Theory: What It Is, and Why It’s Still Relevant After All This Time

There is actually an interesting history to Modern Portfolio Theory (MPT), as it was rooted in the economic and statistical theories of several scholars who built on each other’s separate work. In fact, MPT didn’t come into its own until nearly three decades after it was first posited in the 1950s. Let’s take a look at both the history and thought process of MPT to understand how it works and why it’s still considered a viable and relevant investment strategy.

Harry Markowitz and the Economics of 1952

Young Harry is 25 years old and commencing work on what will be his doctoral thesis at the University of Chicago. He had decided to apply his extensive knowledge and abilities with statistical analysis to stock trading and investment.

While parsing various works by eminent and well-recognized economists and statisticians (specifically John Burr Williams Theory of Investment Value), Markowitz recognized two specific concepts (much to his own disbelief) completely ignored by investors in the early 20th century: risk and diversification. It is on these two concepts that MPT finds its basis.

The Assumptions of MPT

Markowitz outlined four guiding assumptions for his new theory, all of which remain crucial to applied MPT:

1. Investors are risk averse (they don’t like high potential for financial loss when investing)
2. Investors are rational (they don’t care if a methodology or theory is new, they care whether it makes sense)
3. All investors have access to the same information (even more true now than it was in the 1950s thanks to the internet)
4. Returns are normally distributed (you earn money from your investments from more than one financial product or source)

How MPT Works in Practice

Using these assumptions, Markowitz essentially built the foundation and framework that would provide investors with maximal returns for a given amount of risk they were willing to accept via diversification of investment (putting your money in more than one type of financial product). The gains of this group of investments, called a portfolio, were not measured per investment, but in the average gains across all products in the portfolio.

Thus, Markowitz Modern Portfolio Theory stated investors should consider variances in returns from multiple products rather than investing money for a return in isolation. Thanks to his expertise as a statistician, Markowitz demonstrated that if investors considered variances in expected returns versus expected variances of risk, they could maximize returns for minimal risk by diversifying their investment across multiple financial products.

In other words, the relationship between risk and return on investment is proportional. The greater the potential risk, the greater the potential reward. While this is an age old wisdom, Markowitz managed to quantify it and map it out. To Markowitz, the old adage “nothing ventured, nothing gained” was not only true, but he could show you the numbers. Here’s a quick overview of how those numbers work.

The Simplified Mathematics of MPT

The breakdown of the expected return on a portfolio can be calculated using the weighted sum of individual asset returns. Let’s say you have four products in your portfolio are all equally weighted with expected returns of 4,6,10 and 14% respectively. From these numbers, we calculate the average thus:

(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%

Next, you need calculate the potential risk of the portfolio. To do that, you need the four variances of each asset and six correlation values. How did we get that number of correlation values? There are only six possible two-asset combinations when working with four assets.

Here’s where the magic happens: thanks to the asset correlation values, the total risk of the portfolio (called the standard deviation) is lower than the calculated return above. In other words, with diversification your returns consistently outperform your potential risks.

That difference between risk and return plotted on an X and Y axis is dubbed “the efficient frontier” by Markowitz. The lower the risk and the greater expected return, the more efficient the portfolio and the better it will perform for the investor. Putting your money into any proposed portfolio that doesn’t fall on that curve is considered a bad investment.

While MPT and the formulas and mathematics are commonplace practice for investors and portfolio managers today, no such theory had ever been put forward by a statistician and  economist to date in the 1950s. The only problem with Markowitz thesis and subsequent publication of Portfolio Selection was its density, scholarly language, and technical mathematics. The work is filled with graphs, charts, and tables less than comprehensible to the average investor or stock broker. That’s where economist William F. Sharpe comes into the story.

Modern Portfolio Theory and Capital Asset Pricing Model

Due to the complexity of MPT, it took a while to gain traction with all but the most adroit of investment firms, but that changed in 1970 when William F. Sharpe published Portfolio Theory and Capital Markets. In his book, Sharpe posited a theory of pricing stocks, bonds, and securities that relied heavily on investors using MPT as the framework for index investing.

After reading Sharpe, many economists and investors gave Markowitz another look and started to break down his theories and ideas into terms anyone could understand. Within the next 20 years, index investing and portfolio management were the new standard of the financial world.

The Nobel Prize

To honor their extensive work over what was the greater part of their lifetimes and the 20th century, Markowitz, Sharpe, and economist Merton Miller were awarded a joint Nobel Prize for economics in 1990. Not only did they spark a revolution in how people invested, but they also created the model still used today for quantitative financial analysis and tracking/predicting financial trends to this day. The recognition and l the work invested in MPT raises an important question though: if this theory has been around since the 1950s, why are we still using it today?

Why Modern Portfolio Theory is Still Relevant

Markowitz four assumptions are no less relevant today than they were over half a century ago. Investors are still risk averse, but they are also rational. Providing them with a means of optimizing their returns versus their risk continues to be an exceptionally valuable method for brokers and investment firms to this day.

No investor need fear losing everything on a bubble in the economy when they apply MPT to at least a portion of their assets. The standard portfolio investment is 50 percent into real estate, 40 percent in stocks, and 10 percent in bonds. This allocation of resources best follows Markowitz Efficient Frontier, and maintains a high level return. Here’s the reasoning behind the 50-40-10 model:

50-40-10 And Why it Works So Well

Real Estate

Why would investors choose 50 percent in real estate? Real estate has a stable appreciation in value that only goes one way: up. It is exceptionally rare to see a property devalue over time, so allocating half of your portfolio in real estate makes sense so that a large portion of your money is always increasing in value with your properties and is immune to the fluctuations of the stock market. Most investors are generally under-invested in real estate, and if you don’t know how much of your portfolio is invested in real estate, find out and ask for changes.

Stocks

The principal of greater returns for greater risk means you have to put some of your money out there with a greater potential for loss. The conventional wisdom is to 40% of your assets in stocks your broker or investment firm know are going to earn for you over the course of the year. Obviously, how the stock market works means you can see vast increases in your stock value and steep declines over the course of just a few days.

It makes sense to drop a significant amount of your money into stocks to try and earn those big returns, but keeping over half of your money in “sure thing” investments like real estate and bonds is prudent. You don’t want to lose everything if a stock does not perform to expectations and ends up losing you a significant amount of your investment capital.

Bonds

As important as it is to put your money to work to earn, you also need to keep a percentage of your portfolio invested in something guaranteed to increase in value over a set time period. Buying bonds means you are providing money up front for a guaranteed return of a specific percentage after a specific time period has passed. When your bonds mature, the amount they have earned is paid to your portfolio fund and you can reinvest. This not only assures growth, but also protects your money in the event that the economy tanks and your stocks drop in value suddenly.

Are You Investing Using MPT?

Individual investors and those who engage the services of a portfolio manager should understand and apply the principles of Modern Portfolio Theory. It’s been proven time and gain to be the smartest way to invest your money without worrying about absorbing massive losses from high risk investments that don’t pan out.

I also cannot emphasize enough how important it is to be invested in real estate more than stocks or bonds. Real estate is virtually guaranteed to increase in value, and you are insulating yourself from loss simultaneously. Hopefully this article has enlightened you regarding how your money should be invested, and in the future you can ensure you or your financial manager follow the principles outline by MPT.