The term 'Modern Portfolio Theory' is included in the Economics edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Check for lowest price here...
Modern portfolio theory proves to be a model for investing invented by Harry Markowtiz. He outlined many of the ideas in his 1950s book Portfolio Selection. The economist and mathematician claimed that investors could successfully reduce their amount of market risk and still maximize their portfolio returns for that given level of investments. This is actually accomplished by mixing different risk level investments together. If the various investment risks are not correlated, then risky investments with higher returns can actually reduce overall risk in a portfolio.
This Modern Portfolio Theory has come to dominate and become heavily utilized throughout the financial advising industry. Most investors would appreciate the goal of it to reach the greatest potential returns over the long term without having to suffer excessive amounts of market risk in the short term.
Everyone would like to be able to decrease market fluctuations in their portfolios. The way it is possible is by diversifying. The theory demonstrates how investors are able to take individual investments which have high risk and combine them with a few other kinds of investments that are lower risk. The end result is a balance that delivers a better return while providing lower risk than the more volatile investments in the portfolio feature.
Examples of how this works abound throughout the markets. Stocks usually have more risk in the markets than do bonds. Combining bonds with stocks can lower the risk of the stocks and still deliver an acceptable return. With individual stocks, international stocks along with smaller cap stocks carry a greater risk than do the larger cap stocks. If an investor includes all three types of these then the return will be above average while the risk is only average. This works as measured over longer time frames and compared to major benchmarks like the S&P 500.
The theory itself can actually become a little complicated as it mathematically compares different kinds of investments against each other. This does not change an inescapable truth. Markotwitz claimed that no matter how well an investor balances out the portfolio, there are still limitations. In order to secure a greater return on average, investors will have to be willing to accept more risk. The opposite of this is true as well. If an investor wants fewer fluctuations in the portfolio from one month or year to the next, then he or she will have to be stand for lower returns over the long term in order to accomplish this.
There are variations on Modern Portfolio Theory that are used by a wide range of financial advisors and investors. One of these is tactical asset allocation. It takes the parts of MPT that have to do with diversification and re-balancing and applies them to investing.
There are a number of critics to MPT who charge that it is not the best means of investing. Many of these prefer technical analysis methods and like to use trends and market psychology in their strategies. Others put down the buy and hold principle that underlies the Modern Portfolio Theory.
These critics continue to make the argument that market behaviors and trends can be timed. They state that balanced asset allocating misses out on the ability to capture big moves and avoid corrections. The problem with these charges is that market timing is not easy. Countless investors have failed at timing the markets. The majority of them lack the knowledge, temperament, and time to be effective at it consistently.