Modern portfolio theory is a financial theory that describes how investors can construct a portfolio of assets that maximizes the expected return for any given level of risk or minimizes the level of risk for any given rate of expected return.
Modern Portfolio Theory Basics
Modern portfolio theory is based on a few foundational ideas from financial theory.
• Risk vs Reward
Modern portfolio theory is based on the idea that there is a balance between the risk of an asset and its potential reward. The higher the expected return for an asset, the greater the variance of those returns. While this is not a strict linear relationship across all assets, it is a general feature of most assets.
• Systemic Risk
Another key foundational idea of modern portfolio theory is the concept of systemic risk. All assets have a historical relationship relative to the market as a whole that influences their expected future performance and their role in the development of an optimized portfolio according to modern portfolio theory.
Two stocks, for example, can have the same expected return and risk profile, but if one falls by 0.5% for every 1% gain in the market as a whole while the other increases by 2% for the same market gain, then these two stocks will have dramatically different impacts on any portfolio that they are included in.
• Cross-Asset Correlation
The final fundamental element of modern portfolio theory is the existence of correlations between assets. Similar to the concept of systemic risk, this correlation means that different assets will have predictable relative price movements. For example, gold and gold mining companies are likely to increase and decrease in tandem, though not necessarily at a one-to-one relationship.
Building an Optimized Portfolio
Modern portfolio theory uses these 3 foundational ideas to create a system for investors to create optimized portfolios that maximize the expected rate of return for any given degree of risk.
At the center of modern portfolio theory is the concept of the efficient frontier. This is a curved line that represents the maximum possible expected return for every given level of risk in the portfolio.
Any point on the graph that is on the line is the maximum possible expected return for that level of risk, while any point inside the efficient frontier is a sub-optimal portfolio that could be enhanced by altering the assets that it is composed of.
Because all assets have an interrelationship between each other and with the market as a whole, it is simply a matter of finding the optimal combination of assets given their respective risk-reward profile and interrelationships with other assets and the market.
Modern Portfolio Theory and Trading
Modern portfolio theory is absolutely central to contemporary finance, and it is critical that traders understand how it shapes the investment decisions of most financial actors.
Practically every institutional investor will practice modern portfolio theory to some extent, from mutual funds and investment managers to insurance companies and banks.
Investors build portfolios of assets to spread their exposure to risk across multiple different assets, and then they maximize the expected return of those combined assets by examining their interrelationships.
This means that institutional investors act in predictable ways when developing their portfolios or reacting to changing circumstances in the market.
Modern portfolio theory leads to the demand for gold, yen and treasurys during times of risk and uncertainty and it leads to investors who hedge their investments by buying assets that will increase in value while other assets in their portfolio decrease.
This dominance of formulaic investing in contemporary finance means that traders can predict large trades by institutional investors, which allows traders to profit from portfolio re-balancing.
Using modern portfolio theory, traders can predict what certain institutional investors will do in the short term as a result of events that have already occurred without even needing to make accurate forecasts of future market events.
Modern portfolio theory is so absolutely central to the functioning of contemporary markets that it is essential for all day traders to understand the basic concepts behind it.
While the mathematics involved in constructing an optimized portfolio may be slightly complicated, the basic ideas behind modern portfolio theory are both accessible and applicable for the average day trader.