Modern Portfolio Theory and Risk

Updated: Jan 11

If you haven't read the introduction to Modern Portfolio Theory (MPT), we HIGHLY suggest you read this one prior. You can't run without learning how to walk!


As a brief re-cap, we discussed the basic principles of MPT. Essentially, it's a way to calculate how investors can maximize their return given their risk. Hint Hint, it's also what we do. The only difference is that we don't take your money while you're at it.



The graph above, taken from Sitka Pacific Capital, a company that offers financial services in Washington, the portfolio with the least risk would consist of approximately 26% stocks and 74% bonds. Meanwhile, the portfolio with the highest risk would consist of purely stocks or shares.


Relationship Between Risk and Return


The left hand corner of the curve where the minimum risk portfolio is located demonstrates the direct relationship between risk and return. As evident by the volatility on the x-axis and the expected return on the y-axis, we can see that that low risk will generate low returns.


On the other hand, the portfolios located on the top right hand corner had the most risk and as a result, the most returns. This portion of the curve is also referred to as the “efficient frontier”. The efficient frontier is the best possible combination of a certain risk tolerance. And this limit is then used through the process of mean-variance optimization (MVO). MVO allows investors to calculate their biggest award at their level of risk or contrarily, the least amount of risk.


Sub-Optimal Portfolios


Portfolios that lie below the efficient frontier are considered to be sub-optimal because they are not efficient; for the amount of risk they have, they do not provide enough return to warrant that risk in the first place. For the same risk, a more carefully arranged portfolio will generate more return. The area between 60% stocks/40% bonds and 80% stocks/20% bonds represents the portfolios that have medium risk and come with medium returns. Meanwhile, anything above the curve is infeasible because it is unattainable.


Diversification


MPT also brings in the importance of diversification, which is why MPT is extremely useful for investors who are constructing portfolios around exchange traded funds (ETFs).


ETFs And Their Advantages


ETFs have revolutionized the trading world as they give investors access to multiple asset classes very quickly. ETFs also offer fewer commission fees and lower expense ratios because people no longer have to buy the stocks individually. By purchasing ETFs, individuals are able to diversify their portfolio quicker and have lower overall costs.


And because of the advantages they offer when compared to mutual funds such as intraday trading and tax efficiency, ETFs have been growing rapidly over the last few years as they are now worth $4.3 billion in the United States.


Criticisms of MPT


A drawback, or a criticism, of the MPT is how it calculates risk. Because variance is used when calculating portfolio risk, many who oppose MPT feel that it is disregarding downside risk, an indication of how much the investor can stand to lose. As a result, people who are not as risk-averse might find themselves taking more of a liking to the Post-modern portfolio theory (PMPT).


This theory is highly what ETFication is based around. We utilize a mathematical model, specifically an optimization tool that utilizes mean-variance optimization if you want to get all fancy, in order to calculate the most efficient portfolio for YOU. We take into considerations your details and present you with what will be the most efficient according to calculations.


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