Example of Applying Modern Portfolio Theory

(MPS)
 FACEBOOK
 TWITTER
 LINKEDIN

By CRAIG ANTHONY
 Updated Oct 5, 2020
Modern Portfolio Theory (MPT) is a theory in investment and portfolio
management that shows how an investor can maximize a portfolio's expected
return for a given level of risk by altering the proportions of the various assets in
the portfolio. Given a level of expected return, an investor can alter the portfolio's
investment weightings to achieve the lowest level of risk possible for that rate of
return.

Assumptions of Modern Portfolio Theory

At the heart of MPT is the idea that risk and return are directly linked, meaning
that an investor must take on higher risk to achieve greater expected returns.
Another main idea of the theory is that through diversification across a wide
variety of security types, a portfolio's overall risk may be reduced. If an investor is
presented with two portfolios that offer the same expected return, the rational
decision is to choose the portfolio with the lower amount of total risk.

To arrive at the conclusion that the risk, return and diversification relationships
are true, a number of assumptions must be made.

1. Investors attempt to maximize returns given their unique situation.

2. Asset returns are normally distributed.
3. Investors are rational and avoid unnecessary risk.
4. All investors have access to the same information.
5. Investors have the same views on expected returns.
6. Taxes and trading costs are not considered.
7. Single investors are not sizable enough to influence market prices.
8. Unlimited amounts of capital can be borrowed at the risk-free rate.

Some of these assumptions may never hold, yet MPT is still very useful.

Examples of Applying Modern Portfolio Theory

One example of applying MPT relates to a portfolio's expected return. MPT
shows that the overall expected return of a portfolio is the weighted average of
the expected returns of the individual assets themselves. For example, assume
that an investor has a two-asset portfolio worth $1 million. Asset X has an
expected return of 5%, and Asset Y has an expected return of 10%. The portfolio
has $800,000 in Asset X and $200,000 in Asset Y. Based on these figures, the
expected return of the portfolio is:

Portfolio expected return = (($800,000 / $1 million) x 5%) + (($200,000 / $1

million) x 10%) = 4% + 2% = 6%
If the investor wants to ratchet up the expected return of the portfolio to 7.5%, all
the investor needs to do is shift the appropriate amount of capital from Asset X to
Asset Y. In this case, the appropriate weights are 50% in each asset:

Expected return of 7.5% = (50% x 5%) + (50% x 10%) = 2.5% + 5% = 7.5%

This same idea applies to risk. One risk statistic that comes from MPT, known
as beta, measures a portfolio's sensitivity to the market's systematic risk, which is
the portfolio's vulnerability to broad market events. A beta of one means that the
portfolio is exposed to the same amount of systematic risk as the market. Higher
betas mean more risk, and lower betas mean less risk. Assume that an investor
has a $1 million portfolio invested in the following four assets:

Asset A: Beta of 1, $250,000 invested

Asset B: Beta of 1.6, $250,000 invested
Asset C: Beta of 0.75, $250,000 invested
Asset D: Beta of 0.5, $250,000 invested
The portfolio beta is:

Beta = (25% x 1) + (25% x 1.6) + (25% x 0.75) + (25% x 0.5) = 0.96

The 0.96 beta means the portfolio is taking on about as much systematic risk as
the market in general. Assume that an investor wants to take on more risk,
hoping to achieve more return, and decides a beta of 1.2 is ideal. MPT implies
that by adjusting the weights of these assets in the portfolio, the desired beta can
be achieved. This can be done in many ways, but here is an example that
demonstrates the desired result:

Shift 5% away from Asset A and 10% away from Asset C and Asset D. Invest
this capital in Asset B:

New beta = (20% x 1) + (50% x 1.6) + (15% x 0.75) + (15% x 0.5) = 1.19
The desired beta is almost perfectly achieved with a few changes in portfolio
weightings. This is key insight from MPT.