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Theory of Portfolio Investment: A Review of Literature

Profile image of Worapot "Warren Wu"  Ongkrutaraksa

This essay summarizes the modern portfolio investment theory after World War II to date. Its development spans three consecutive decades from 1950s to 1970s namely, the portfolio theory and the single-factor model which are based on the mean-variance efficiency (MVE) for assets allocation pioneered by Markowitz and simplified by Sharpe, the capital asset pricing model (CAPM) developed independently by Sharpe, Lintner, and Mossin, and the arbitrage pricing theory (APT) by Ross. Many subsequent models are either the variants or extensions of the original theory of portfolio selection of Markowitz. However, those models, when put into tests, are not empirically robust and often fail to explain certain market phenomena. Yet, without them we shall lack a reliable benchmark against which actual market prices and returns of financial assets are measured in order to see whether or not they are correctly valued and economically justified in terms of their ex ante fundamentals as well as their ex post performance.

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Modern Portfolio Theory: What MPT Is and How Investors Use It

modern portfolio theory literature review

Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).

modern portfolio theory literature review

What Is the Modern Portfolio Theory (MPT)?

The modern portfolio theory (MPT) is a practical method for selecting investments in order to maximize their overall returns within an acceptable level of risk. This mathematical framework is used to build a portfolio of investments that maximize the amount of expected return for the collective given level of risk.

American economist Harry Markowitz pioneered this theory in his paper "Portfolio Selection," which was published in the Journal of Finance in 1952. He was later awarded a Nobel Prize for his work on modern portfolio theory.

A key component of the MPT theory is diversification. Most investments are either high risk and high return or low risk and low return. Markowitz argued that investors could achieve their best results by choosing an optimal mix of the two based on an assessment of their individual tolerance to risk.

Key Takeaways

  • The modern portfolio theory (MPT) is a method that can be used by risk-averse investors to construct diversified portfolios that maximize their returns without unacceptable levels of risk.
  • The modern portfolio theory can be useful to investors trying to construct efficient and diversified portfolios using ETFs.
  • Investors who are more concerned with downside risk might prefer the post-modern portfolio theory (PMPT) to MPT.

Investopedia / Matthew Collins

Understanding the Modern Portfolio Theory (MPT)

The modern portfolio theory argues that any given investment's risk and return characteristics should not be viewed alone but should be evaluated by how it affects the overall portfolio's risk and return. That is, an investor can construct a portfolio of multiple assets that will result in greater returns without a higher level of risk.

As an alternative, starting with a desired level of expected return, the investor can construct a portfolio with the lowest possible risk that is capable of producing that return.

Based on statistical measures such as variance and correlation , a single investment's performance is less important than how it impacts the entire portfolio.

Acceptable Risk

The MPT assumes that investors are risk-averse, meaning they prefer a less risky portfolio to a riskier one for a given level of return. As a practical matter, risk aversion implies that most people should invest in multiple asset classes .

The expected return of the portfolio is calculated as a weighted sum of the returns of the individual assets. If a portfolio contained four equally weighted assets with expected returns of 4%, 6%, 10%, and 14%, the portfolio's expected return would be:

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

The portfolio's risk is a function of the variances of each asset and the correlations of each pair of assets. To calculate the risk of a four-asset portfolio, an investor needs each of the four assets' variances and six correlation values, since there are six possible two-asset combinations with four assets. Because of the asset correlations, the total portfolio risk, or standard deviation , is lower than what would be calculated by a weighted sum.

Benefits of the MPT

The MPT is a useful tool for investors who are trying to build diversified portfolios. In fact, the growth of exchange-traded funds (ETFs) made the MPT more relevant by giving investors easier access to a broader range of asset classes.

For example, stock investors can reduce risk by putting a portion of their portfolios in government bond ETFs . The variance of the portfolio will be significantly lower because government bonds have a negative correlation with stocks. Adding a small investment in Treasuries to a stock portfolio will not have a large impact on expected returns because of this loss-reducing effect.

Looking for Negative Correlation

Similarly, the MPT can be used to reduce the volatility of a U.S. Treasury portfolio by putting 10% in a small-cap value index fund or ETF. Although small-cap value stocks are far riskier than Treasuries on their own, they often do well during periods of high inflation when bonds do poorly. As a result, the portfolio's overall volatility is lower than it would be if it consisted entirely of government bonds. Moreover, the expected returns are higher.

The modern portfolio theory allows investors to construct more efficient portfolios. Every possible combination of assets can be plotted on a graph, with the portfolio's risk on the X-axis and the expected return on the Y-axis. This plot reveals the most desirable combinations for a portfolio.

For example, suppose Portfolio A has an expected return of 8.5% and a standard deviation of 8%. Assume that Portfolio B has an expected return of 8.5% and a standard deviation of 9.5%. Portfolio A would be deemed more efficient because it has the same expected return but lower risk.

It is possible to draw an upward sloping curve to connect all of the most efficient portfolios. This curve is called the efficient frontier .

Investing in a portfolio underneath the curve is not desirable because it does not maximize returns for a given level of risk.

Criticism of the MPT

Perhaps the most serious criticism of the MPT is that it evaluates portfolios based on variance rather than downside risk .

That is, two portfolios that have the same level of variance and returns are considered equally desirable under modern portfolio theory. One portfolio may have that variance because of frequent small losses. Another could have that variance because of rare but spectacular declines . Most investors would prefer frequent small losses, which would be easier to endure.

The post-modern portfolio theory (PMPT) attempts to improve modern portfolio theory by minimizing downside risk instead of variance.

Frequently Asked Questions

What is the difference between the modern portfolio theory and the post-modern portfolio theory.

The modern portfolio theory (MPT) was a breakthrough in personal investing. It suggests that a conservative investor can do better by choosing a mix of low-risk and riskier investments than by going entirely with low-risk choices. More importantly, it suggests that the more rewarding option does not add additional overall risk. This is the key attribute of portfolio diversification.

The post-modern portfolio theory (PMPT) does not contradict these basic assumptions. However, it changes the formula for evaluating risk in an investment in order to correct what its developers perceived as flaws in the original.

Followers of both theories use software that relies on either MPT or PMPT to build portfolios that match the level of risk that they seek.

What Are the Benefits of the Modern Portfolio Theory?

The modern portfolio theory can be used to diversify a portfolio in order to get a better return overall without a bigger risk.

Another benefit of the modern portfolio theory (and of diversification) is that it can reduce volatility. The best way to do that is to choose assets that have a negative correlation, such as U.S. treasuries and small-cap stocks.

Ultimately, the goal of the modern portfolio theory is to create the most efficient portfolio possible.

Journal of Global Economics, Management and Business Research

Published: 2015-11-11

Page: 45-52

Issue: 2016 - Volume 6 [Issue 1]

Review Article

MODERN PORTFOLIO THEORY: A REVIEW OF LITERATURE

AMIR KHAN *

COMSATS Institute of Information Technology, Abbottabad, Pakistan.

YASIR BIN TARIQ

Department of Management Sciences, COMSATS Institute of Information Technology, Abbottabad, Pakistan.

MUHAMMAD KAMRAN KHAN

Department of Management Sciences, University of Haripur, Khyber Pakhtunkhwa, Pakistan.

*Author to whom correspondence should be addressed.

In this paper the Modern Portfolio Theory is explained which contains basic two theories, the Markowitz theory of Portfolio and the asset pricing theory. After review of number of research paper related to the particular topic it is concluded that there are two different opinions and results related to the Modern Portfolio Theory (MPT). Some of the researchers are in the favor of the MPT, having the opinion that collectively, both the theories provide a hypothetical framework for identification & the measurement of risk related to the investment and formulation of the associations between expected risk and return. MPT is having better sharing of risk compare to the traditional approach used by the portfolios. Some other researcher reveals that CAPM is essentially an ex ante notion that provide with a way to think concerning the trade-off of risk and return, in the circumstance of proficiently diversified investment portfolios. On the other hand there are number of researchers who are criticizing the Modern Portfolio Theory (MPT) having the view that after comprehensive review a number of flaws were pointed out among them the unsophisticated assumptions a significant flaw pointed out is a straight correlation of returns and risks.

Keywords: Portfolio theory, CAPM, risk, return

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  1. A novel approach to using modern portfolio theory

    1. Introduction This article discusses our novel use of modern portfolio theory (MPT) with different risk-reward ratios. Currently, investors use MPT with risk-reward ratios such as the Sharpe or Sortino ratios, and, at the end of an investment period, they evaluate their portfolio performance using ratios such as the Sterling and Treynor ratios.

  2. Modern Portfolio Theory: a Review of Literature

    Published 2016 Economics, Business Journal of Global Economics In this paper the Modern Portfolio Theory is explained which contains basic two theories, the Markowitz theory of Portfolio and the asset pricing theory.

  3. A Comprehensive Analysis of The Modern Portfolio Theory

    In addition to the con pets forwarded by active and passive portfolio theory, the MPT (modern portfolio theory) outlines the importance of diversification in reducing the risk associated...

  4. Limitations and Critique of Modern Portfolio Theory: A ...

    Limitations and Critique of Modern Portfolio Theory: A Comprehensive Literature Review January 2024 Authors: Hanwen Zhang Abstract This paper employs a systematic literature review...

  5. PDF Modern portfolio theory, 1950 to date

    1 Theory and Investment Analysis. There are also good reviews in more ad-vanced doctoral-level texts such as Ingersoll (1987) or Huang and Litzenberger (1988). There are also some careful mathematical treatments (SzegoÈ, 1980). Fi-nally, good review articles such as Constantinides and Malliaris (1995) exist.

  6. A Simplified Perspective of the Markowitz Portfolio Theory

    This paper presents a simplified perspective of Markowitz' contributions to Modern Portfolio Theory, foregoing in-depth presentation of the complex mathematical/statistical models typically...

  7. Modern Portfolio Theory: A Review of the Work Done on Performance

    This paper reviews the literature on The Modern Portfolio Theory starting from the contribution of Markowitz. It discusses the merits and de merits of the theory as reviewed through empirical findings, theoretical developments and modeling works.

  8. Modern Portfolio Theory

    This chapter reviews the Markowitz's work on modern portfolio theory. It discusses briefly the portfolio selection approach proposed by Markowitz and subsequently highlights the problems encountered in practice. It also presents the empirical artefacts of the optimized portfolios.

  9. The Modern Portfolio Theory

    Literature Review 2.1 What is Modern Portfolio Theory? The Modern Portfolio Theory is considered a framework that infuences the decision of portfolio managers when constructing a portfolio based on its expected return and its risk-level [5]. MPT involves a number of theories but it is largely based on Harry

  10. Theory of Portfolio Investment: A Review of Literature

    Theory of Portfolio Investment: A Review of Literature Worapot "Warren Wu" Ongkrutaraksa 1996 This essay summarizes the modern portfolio investment theory after World War II to date.

  11. PDF Review on the Modern portfolio theory and optimization model

    connections between expected return and risk. Iasset t is criticalthat Modern portfolio theory is a theory that is different from any theories of asset pricing. Therefore, it should be understood that the validity of modern portfolio theory does not depend on the asset pricing theory, which is not clear to many critics of MPT [7] [8].

  12. Modern Portfolio Theory: Foundations, Analysis, and New ...

    Modern Portfolio Theory provides a summary of the important findings from all of the financial research done since MPT was created and presents all the MPT formulas and models using one consistent set of mathematical symbols.

  13. [PDF] Portfolio theory: a review

    Portfolio theory: a review. T. J. Brennan, A. Lo, Tri-Dung Nguyen. Published 2007. Economics, Business, Mathematics. Pioneered by the Nobel-prize-winning economist Harry Markowitz over half a century ago, portfolio theory is one of the oldest branches of modern financial economics, and consists of methods for allocating funds among financial ...

  14. Energy planning and modern portfolio theory: A review

    An exhaustive review of previous studies on modern portfolio theory (MPT) and its application to energy planning and electricity production was done by [11]. While most of the authors defines ...

  15. Portfolio Theory

    10.2 Literature review. Portfolio theory and the concept of ... It can be stated that modern portfolio theory represents a theory of finance which attempts to maximize portfolio's expected return for a given portfolio risk or equivalently minimize the risk for a given level of expected return. The Markowitz model suggests that a single asset ...

  16. PDF The modern portfolio theory as an investment decision tool

    This research paper is academic exposition into the modern portfolio theory (MPT) written with a primary objective of showing how it aids an investor to classify, estimate, and control both the kind and the amount of expected risk and return in an attempt to maximize portfolio expected return for a given amount of portfolio risk, or equivalently...

  17. Towards a theoretical foundation for project portfolio management

    Modern Portfolio Theory (MPT) In the early 1950s, Harry Markowitz began developing his modern portfolio theory (MPT). In applying the concepts of variance and co-variance, Markowitz showed that a diversified portfolio of financial assets could be optimized to deliver the maximum return for a given level of risk (Teach & Goff, 2003).

  18. Modern Portfolio Theory: What MPT Is and How Investors Use It

    Modern Portfolio Theory - MPT: Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of ...

  19. PDF A Modern Portfolio Theory Approach to Asset Management in the ...

    Chapter 2 Literature Review 2.1 Introduction 1 2.2 Portfolio Theory 18 2.2.1 Modern Portfolio Theory 18 2.2.2 Investor Preferences 19 2.2.3 The efficient frontier 20 2.2.4 Capital Asset Pricing Model 21 2.3 Property Portfolio Strategy and Investment

  20. REVIEW ARTICLE ON MODERN PORTFOLIO THEORY: MARKOWITZ MODEL

    Psychological Sciences: A Review of Modern Psychology. February 1974 · PsycCRITIQUES. Ralph H. Turner. PDF | On Feb 26, 2020, Krishna Khambholiya published REVIEW ARTICLE ON MODERN PORTFOLIO ...

  21. Modern Portfolio Theory

    A through guide covering Modern Portfolio Theory as well as the recent developments surrounding it Modern portfolio theory (MPT), which originated with Harry Markowitz's seminal paper "Portfolio Selection" in 1952, has stood the test of time and continues to be the intellectual foundation for real-world portfolio management. This book presents a comprehensive picture of MPT in a manner that ...

  22. Modern Portfolio Theory: a Review of Literature

    In this paper the Modern Portfolio Theory is explained which contains basic two theories, the Markowitz theory of Portfolio and the asset pricing theory. After review of number of research paper related to the particular topic it is concluded that there are two different opinions and results related to the Modern Portfolio Theory (MPT). Some of the researchers are in the favor of the MPT ...