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Modern Portfolio Theory

Modern Portfolio Theory (MPT) – like the name suggests – is an academic theory that applies to investment portfolio design and management. Developed by Harry Markowitz in 1952, MPT grew out of Markowitz’s research into what he called “portfolio selection” while a graduate student at the University of Chicago. It later helped to earn him a share of the first Nobel Prize in economics, in 1990.

Based on the notion that investors are rational and, as such, prefer to maximize their potential reward for a given amount of risk (or, conversely, minimize their risk for a given amount of reward), Markowitz claimed that “…the riskiness of the portfolio had to do not only with the riskiness of the individual securities therein, but also to the extent that they moved up and down together.” Considering the correlations among different types of securities (stocks, bonds, etc.), MPT suggested that by including securities whose variances were not correlated – one zigged while the other zagged – the investor could design an “efficient portfolio” that maximized return while limiting risk. With MPT, thus was born the idea that investors could have their cake and eat it, too.

Like many academic theories, MPT is less elegant in practice, where investors often don’tbehave rationally (Indeed, a competing theory emphasizing the ir-rational behavior of investors is emerging as a potentially more compelling and useful framework for portfolio decision-making). The broad market decline of 2008, during which assets of all kinds suffered significant losses – and safe havens were few and far between – further weakened the theory that returns could be maximized while risks were minimized, simply through the selection of non- or less-correlated assets.

The shortcomings of Markowitz’s theory notwithstanding, MPT remains a useful framework for dealing with investment portfolio design and management, largely because no other method (including the “behavioral” theory) has emerged as a practical, workable alternative for portfolio construction. MPT may not work, perfectly, every time, but the simple notion of including different types of securities together in one’s portfolio – akin to “not putting all of your eggs in one basket” – remains an inherently logical and sensible one to most investors.

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