Modern Portfolio Theory – How Can You Make Money on the Efficient Frontier?

Daniel Penzing
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What Is Modern Portfolio Theory?

Modern portfolio theory (MPT) can be somewhat complex at times. It is a way to determine how to invest your money in order to maximize returns while minimizing risk. There are eight different factors to determine your risk tolerance including systematic risk, key investment drivers, market risk, and liquidity. Once an investor has determined how they would like to invest, they can then determine the most efficient allocation to reach their desired goals.

Modern Portfolio Theory was introduced by Harry M. Markowitz in his Ph.D. thesis in 1952. His work was an attempt to reduce the amount of risk an investor takes in a portfolio. The theory is based on a number of assumptions and theoretical conditions.

MPT was developed in 1952 using a rather fuzzy concept of risk. Its assumptions are still closely related to the popular measurement of risk known as beta. The theory is based on two mathematical formulas. The first, the concept of covariance, is used to determine how returns on two different securities move together. The second formula, the historical correlation between assets, is used to determine how two stocks move.

Beta is a measurement used to determine risk of an investment portfolio to the market. The formula is the covariance of the portfolio with returns on the market index. An investment has a beta that is greater than one if the portfolio returns move up and down more than the market, which is considered more risky.

The Best Portfolios Are on the Efficient Frontier

Modern portfolio theory is one of the most important discoveries in finance. It was first proposed by Harry Markowitz in a 1952 article and made its way into mainstream textbooks in the 1960s. Since that time, it has become the foundation for investment management.

Modern portfolio theory explains how an investor can quantify the risk and return in any investment market and construct a portfolio whose return is as close to the risk free rate of return as possible. The theory also tells us that each person has a unique risk aversion level. Investors will decide how to construct their portfolios based on their own unique risk aversion levels.

How You Can Use MPT in Your Portfolio

Modern Portfolio Theory (MPT) is a portfolio management theory developed by economist Harry Markowitz in the 1950s. The theory was initially published in the Journal of Finance, and a few decades later, Markowitz was awarded Nobel Prize for his contributions.

In his paper titled “Portfolio Selection”, Markowitz proposed a portfolio management framework that takes into consideration risk and return. He demonstrated that the best expected return comes from the portfolio with minimum risk (called the efficient frontier).

Before modern portfolio theory (MPT) was developed, investors considered two metrics to gauge the performance of the portfolio – the expected return and the standard deviation. Although these two metrics were sufficient to measure performance before MPT, it is no longer true after MPT.

Before we understand why the two pre-MPT metrics are no longer sufficient, it helps to understand the Markowitzian way of creating a portfolio.

Markowitzian Theory

Looking at different asset classes, it becomes evident that you do not have to hold all the assets available. For example, if there are three equity assets, you need not hold all of them. To create a portfolio, you may hold one of them, because the other two…and thousands more…provide the same expected return by holding any random one.

Potential Drawbacks to MPT

Modern Portfolio Theory (MPT) is a finance theory developed by Harry Markowitz. MPT is currently the most widely used investment theory and underpins most modern portfolio theory.

The theory states that investors can make the most profit by allocating assets while trying to maximize the expected return for any level of risk involved. Essentially, it is a method to help an investor create the best portfolio and offers advice on how to maximize the portfolio’s performance.

MPT states that if an investor chooses a diversified portfolio that suits that investor’s risk tolerance and for which the investor has accurate market forecasts, then the investor can maximize his profits by keeping the level of risk constant.

This method suggests that you find the sweet spot on the efficient frontier curve and place your investments there. The efficient frontier curve shows the perfect correlation between risk and expected return, based on historical data. The efficient frontier curve is horizontal, and it is derived at two points: the least amount of risk and the least amount of expected return.

This is why MPT was originally designed to work for stocks and bonds. It assumes that the risk of stocks is more than the risk of bonds and that all risky assets will follow the efficient frontier curve.

Conclusion

Portfolio theory is an established framework for evaluating portfolios and designing portfolios to maximize risk-adjusted returns.

This theory not only helps to optimize the portfolio construction, but also emphasizes significant moral issues that the financial industry and the investors have to face as the financial crisis continues. According to the modern portfolio theory, financial institutions and other investors can both take advantage of reasonably efficient markets and manage the risk of investment.

There are two basic principles of portfolio theory, namely the Market Line and the Efficient Frontier. Investors can apply these principles when exploring the efficient portfolio in order to maximize the return and minimize the risk.

The basic principle of the modern portfolio theory is that the efficient portfolio is one with a higher rate of return than other portfolios. However, this does not mean that the risk associated with the given portfolio is low. The investor should fully understand the risks associated with the different portfolios and use the modern portfolio theory in order to determine the efficient portfolio.

A portfolio is defined in finance as the list of stocks and bonds held by a single investor. Therefore, it is essential to analyze a portfolio before deciding on how to invest. The portfolio theory can help you find the best way to invest. So, if you are looking to invest, it is essential that you familiarize yourself with the modern portfolio theory. You can use this theory in order to make better investment decisions.