Harry Markowitz’s Modern Portfolio Theory: The Efficient Frontier

What is MPT?

Modern Portfolio Theory (MPT) is an investing model in which investors invest with the motive of taking
the minimum level of risk and earning the maximum amount of return for that level of acquired risk. The
modern portfolio theory is a helpful tool for the investors as it helps them in choosing the different types
of investments for the purpose of the diversification of the investment and then making one portfolio by
considering all the investments.

According to the modern portfolio theory, all the investments that are selected are combined together
in a way that reduces the risk in the market through the means of diversification and, at the same time,
also generates a good return in the long term to the investors.

Markowitz created a formula that allows an investor to mathematically trade off risk tolerance and
reward expectations, resulting in the ideal portfolio.

This theory was based on two main concepts:

1. Every investor’s goal is to maximize return for any level of risk

2. Risk can be reduced by diversifying a portfolio through individual, unrelated securities

MPT works under the assumption that investors are risk-averse, preferring a portfolio with less risk for a
given level of return. Under this assumption, investors will only take on high-risk investments if they can
expect a larger reward.

Consider the following example:

A “rational investor” is asked to choose between two investments: Investment A and Investment B. Both
are expected to increase in value by 6 percent each year. However, Investment B is considered twice as
volatile as Investment A, meaning its value fluctuates at twice the magnitude of Investment A’s value
fluctuations.

MPT suggests that a rational investor will always choose the less volatile asset, in this case Investment A,
so long as both options provide an equivalent expected return.

A portfolio’s overall risk is computed through a function of the variances of each asset, along with the
correlations between each pair of assets. Asset correlations affect the total portfolio risk, formulating a
smaller standard deviation than would be found by a weighted sum.

Under the MPT—or mean-variance analysis—an investor can hold a high-risk asset, mutual fund, or
security, so long as this high-risk investment is minimized by all underlying assets. The portfolio itself is
balanced in a way that its overall risk is lower than some of its underlying investments.
Assumptions of Modern Portfolio Theory
4. Markowitz brought out the theory to find out how the security returns are correlated to each other.
By combining the assets in such a way that they give the lowest risk maximum returns could be brought
out by the investor.

5. The investors base their decisions on the expected rate of return of an investment. The expected rate
of return can be found out by finding out the purchase price of a security dividend by the income per
year and by adding annual capital gains.

6. From the above, it is clear that every investor assumes that while making an investment he will
combine his investments in such a way that he gets a maximum return and is surrounded by minimum
risk.

7. The investor can reduce his risk if he adds investment to his portfolio.
8. The investor assumes that greater or larger the return that he achieves on his investments, the higher
the risk factor surrounds him. On the contrary, when risks are low the return can also be expected to be
low.

9. An investor should be able to get higher return for each level of risk “by determining the efficient set
of securities”

A portfolio of assets under the above assumptions is considered efficient if no other asset or portfolio of
assets offers a higher expected return with the same or lower risk with the same or higher expected
return. Diversification of securities is one method by which the above objectives can be secured. The
unsystematic and company related risk can be reduced by diversification into various securities and
assets whose variability is different and offsetting or put in different words which are negatively
correlated or not correlated at all.
Diversification
Modern Portfolio Theory suggests diversification of all your securities and asset classes and not putting
all your eggs in one basket. is a popular saying on the stock market. It advises investors not to invest all
their capital in one area since they would risk losing their entire capital if a crisis came up. Instead, it
suggests looking into a variety of capital investments that vary in terms of risk and return. This process
of spreading risks and minimizing chances of a total loss is called diversification. Studies have shown that
it can minimize portfolio risk by 25-30% (Bernstein, 2000

Hence, a well-informed investor will now invest both into low priced stock and high priced stock to
maximize possible return over time. As a famous adage says, the whole is greater than the sum of its
parts. The risk in a portfolio is always lesser than risk inherent in holding any of the individual stocks,
provided the stocks are well-diversified. Also, your portfolio should be able to balance risk and reward in
such a way that you get the highest return at an acceptable level of risk.

The Efficient Frontier

An optimal portfolio is one that occupies the ‘efficient’ parts of the risk-return premium spectrum. It
satisfies the requirement that no other collection exists with a higher expected return at the same
standard deviation of the return (risk measure).

Different combinations of assets produce different levels of return. The optimal portfolio concept
represents the best of these combinations, those that provide the maximum possible expected return
for a given level of acceptable risk.

 At every level of return, investors can create a portfolio that offers the lowest possible risk.
 For every level of risk, investors can create a portfolio that offers the highest return.

The optimal portfolio does not focus on investments with either high expected returns or low risk. It
aims to balance stocks carrying the best potential returns with acceptable risk. When we plot these, we
get the Efficient Frontier.

Any portfolio that falls outside the Efficient Frontier is considered sub-optimal for one of two reasons:

1. It carries too much risk relative to its return, or too little return relative to its risk.
2. A portfolio that lies below the Efficient Frontier doesn’t provide enough return when compared
to the level of risk. Portfolios found to the right of the Efficient Frontier have a higher level of
risk for the defined rate of return.

At every point on the Efficient Frontier, investors can construct at least one portfolio from all available
investments that features the expected risk and return corresponding to that point. A portfolio found on
the upper portion of the curve is efficient, as it gives the maximum expected return for the given level of
risk.
The Efficient Frontier offers a clear demonstration of the power behind diversification. There’s no
singular Efficient Frontier, because investors can alter the number and characteristics of the assets to
conform to their needs.

How to Apply MPT

Time horizon For a person saving for retirement, it might be several years, or even a decade or
more. For an institutional portfolio manager, it might be one to three years. For a hedge fund, the
horizon might be a day, a week, or a quarter. For an institutional endowment, it can be forever.

Sources of return For a person saving for retirement, they probably consist of the asset classes
that the portfolio will comprise. For a portfolio manager hoping to beat a benchmark, they might consist
of sources of return believed to lead to higher performance (these days the sources are often called
“smart betas.”) For an endowment, they might also include other factors, such as credit or illiquidity.

Sources’ expected returns MPT encourages the investor use judgment. If asset valuations seem
high, the experienced investor might reason that future returns may be lower than in the past. Although
the examples in the 1950s paper and book use historical data for the purpose of illustration, MPT does
not tell you how to set expected returns.

Sources’ expected covariances with each other MPT encourages the investor to consider
as much historical information as possible. This does not necessarily mean, however, using a snapshot of
the historical record as the expected risks of the future. Volatility varies with time; take special care to
calibrate volatility expectations from sources whose historical data are different lengths.

Sources’ expected ratio of return to risk MPT is very sensitive to assumptions! When plotted on
a graph of expected return vs. expected risk, are the plots more or less linear? If not, you can almost
guess by visual inspection which sources will appear in the optimal solution: those with the highest ratio
of expected return to risk (however defined). Consider whether that is reasonable, or whether your
assumptions are overfitted (that is, they depend too much on past results). Repeat the above steps as
often as necessary to limit the degree of overfit in your assumptions.
Types of Modern Portfolio Theory Investing Strategies
When choosing investments in accordance with MPT, your goal shouldn't be to accept the highest risk to
extract the highest returns.

Instead, your portfolio should be on what Markowitz called the "efficient frontier," meaning it should
balance risk and reward in such a way that you get the highest return at an acceptable level of risk.2

There are several ways to accomplish this goal.

Strategic Asset Allocation: It’s essential to create a smart portfolio that consists of assets and
investments with no direct correlation. They should also not move up or down under the same market
conditions. You include these investments in your portfolio in fixed percentages. For instance, stocks are
risker investment than bonds, as an asset class. Hence, a portfolio consisting of both stocks and bonds
will give a reasonable return for a relatively lower level of risk.

Also, as stocks and bonds are correlated negatively, this Modern Portfolio Theory strategy minimises
substantial loss in the overall portfolio, when any one of the assets performs poorly.

In an investment level, foreign stocks and small-cap stocks are usually higher in risk than large-cap
stocks. Following Modern Portfolio Theory, you could combine all three to potentially achieve above-
average returns compared to a benchmark such as the S&P 500.

A portfolio of mutual funds formed with Modern Portfolio Theory guidelines could consist of the
following: 30 percent large-cap stock, 15 percent small-cap stock, 15 percent foreign stock, 30 percent
intermediate-term bond, 5 percent cash/money market.

It’s essential to regularly assess your portfolio and rebalance it or bring it back to its original asset
allocation. This would help you to overhaul certain assets and keep your holdings in sync with your
investment goals.

Two-fund theorem an investor can hold two separate funds in his portfolio- one with stocks and
the other one with bonds. This would help him to simplify the process. They would not have to pick any
individual stock. The two-fund portfolio would consist of 50 percent large-cap, mid-cap and small-cap
shares, and 50 percent in corporate bonds, short term, medium-term and intermediate-term
government bonds.
CRITICISM OF THE THEORY
Despite its theoretical relevance, the MPT has been highly criticised; its simplistic assumptions being a
predominant bias. Critics question its viability as an investment strategy, because its model of financial
markets does not match the real world in many ways

The theory does not really model the market The risk, return, and correlation measures used by
MPT are based on expected (forecast) values, which means that they are mathematical statements
about the future (the expected value of returns is explicit in such equations, and implicit in the
definitions of variance and covariance). In practice, investors must substitute predictions based on
historical measurements of asset return and volatility for these values in the equations. Very often, such
expected values fail to take account of new circumstances which did not exist when the historical data
were generated. More fundamentally, investors are stuck with estimating key parameters from past
market data because the MPT attempts to model risk in terms of the likelihood of losses, but says
nothing about why those losses might occur. The risk measurements used are probabilistic in nature,
not structural. This is a major difference as compared to many engineering approaches to risk
management.

The Theory does not consider personal, environmental, strategic, or social dimensions
of investment decisions
It only attempts to maximize risk-adjusted returns, without regard to other consequences. In a narrow
sense, its complete reliance on asset prices makes it vulnerable to all the standard market failures such
as those arising from information asymmetry, externalities, and public goods. It also rewards corporate
fraud and dishonest accounting. More broadly, a firm may have strategic or social goals that shape its
investment decisions, and an individual investor might have personal goals. In either case, information
other than historical returns (as suggested by the MPT) is relevant.

The MPT does not take cognisance of its own effect on asset prices ‫پ‬
Diversification eliminates non-systematic risk, but, at the cost of increasing the systematic risk.
Diversification forces the portfolio manager to invest in assets without analysing their fundamentals;
solely for the benefit of eliminating the portfolio’s non-systematic risk (the capital Omisore et al. 27
asset pricing investment in all available assets) (Chandra, 2003). This artificially increased demand
pushes up the price of assets that, when analysed individually, would be of little fundamental value. The
result is that the whole portfolio becomes more expensive and, as a result, the probability of a positive
return decreases (that is, the risk of the portfolio increases). The legitimacy of the modern portfolio
theory has been challenged by financial analysts who often cite Warren Buffett as a rule breaker.
Warren Buffett, a major financial market referral with successful financial takeovers in his resume, is not
a typical investor. Unlike the average mutual fund manager, Buffet often buys companies and then
manages them. He provides them with economies of scale, lower cost of capital and the benefits of his
managerial wisdom. And when he takes large portions in companies, he often gets a board seat. So
perhaps his great returns are more a result of his managerial skills than his investment skills, or some
combination of both. This, obviously, is not congruent with the line of thought of MPT proponents
(Sabbadini, 2010).
Conclusion
The main idea or the purpose of the Modern portfolio theory says that the risk is
undertaken and return expected linked directly, which means that in order to
achieve the greater rate of expected returns, an investor must have to take a
higher level of risk. Also, the theory says that the overall risk of the portfolio
having securities can be reduced through the means of diversification.

In case two different portfolios are given to the investor having the same level of
expected return, then the rational decision would be to choose the portfolio
having lower total risk.

Modern Portfolio Theory, even though it is accepted widely all over the world and
also applied by different investment institutions, but at the same time, it has also
been criticized by different persons. However, regardless of the different criticism,
Modern portfolio theory is a working strategy having a diversified investment that
is implemented by different risk managers, investment institutions, and related
persons.