Modern Portfolio Theory

What is Modern Portfolio Theory?  Modern Portfolio Theory (MPT) is a framework for constructing investment portfolios that maximize expected return for a given level of risk. Developed by Harry Markowitz in 1952, MPT emphasizes diversification—the idea that combining assets with different risk-return profiles can reduce overall portfolio volatility while maintaining strong returns.

The theory assumes that investors are risk-averse, meaning they prefer lower risk for the same expected return. It introduces the concept of the efficient frontier, which represents the optimal portfolios that offer the highest return for a given risk level. MPT also considers correlation between assets, suggesting that adding negatively correlated assets can improve portfolio stability.

While MPT remains foundational in finance, critics argue that it relies on historical data and assumes rational investor behavior, which may not always hold true in real markets.

According to MPT. if you combine asset classes that zig and zag in a portfolio, even though each asset class by itself may be quite volatile, the volatility of the entire portfolio can be quite low.

In fact, in some cases you can add a volatile investment to a portfolio and, as long as that investment shows little correlation to everything else, you may actually lessen the volatility of the entire portfolio.

Correlation is measured on a scale of minus 1 to plus 1. Two investments with a correlation of 1 are perfectly correlated: They move up and down in sync. Two investments with a correlation of –1 have perfect negative correlation: When one goes up, the other goes down by the same amount.

A correlation of zero means that there is no correlation between two investments: When one goes up, the other may go up or down; there’s simply no predicting. In the real world, negative correlations of two productive investments are hard to find, but you can find investments that have close to zero correlation.

A good example from history is the negative correlation between stocks and bonds. Bonds as a whole generally move up and down independent of stock prices. Some bonds — such as long-term Treasuries — tend to have negative correlation to stocks, generally climbing during times of recession (often in response to dropping interest rates in combination with stock-investor panic that drives up demand for security).But other bonds, such as U.S. high-yield bonds, tend to move more in sync with the stock market.

When choosing a bond or bond fund, you should consider the correlation that your new investment is going to have with your existing investments. High-yield bonds pay considerably more interest than Treasuries, but they aren’t going to give you nearly the same diversification power if your portfolio is made up mostly of U.S. stocks.