Modern Portfolio Theory (MPT) — what is it?
Harry Markowitz's Modern Portfolio Theory is the foundation of diversification. Learn how to build an optimal investment portfolio according to MPT.
What is Modern Portfolio Theory?
Modern Portfolio Theory (MPT) is a concept developed by Harry Markowitz in 1952 (Nobel Prize in Economics in 1990). Key idea: don't evaluate investments in isolation — the entire portfolio matters. Through the right combination of assets, you can achieve higher returns at the same risk or the same return at lower risk.
Key MPT concepts
Efficient Frontier
A set of portfolios offering the highest expected return for a given risk level. Portfolios below the efficient frontier are suboptimal — you can improve returns without increasing risk.
Asset correlation
If two assets move in the same direction (high correlation), diversification is weak. The best diversification involves assets with low or negative correlation — e.g., stocks and bonds.
Risk = standard deviation
MPT defines risk as volatility of returns (standard deviation). Higher volatility = higher risk. This is a simplification (investors fear losses more than they enjoy gains), but useful.
MPT in practice
Simple portfolio example
| Asset class | Share | Role |
|---|---|---|
| Global stocks (ETF) | 60% | Growth |
| Government bonds | 30% | Stabilization |
| Gold | 10% | Diversification |
Such a portfolio historically achieved about 7% annually with volatility lower than a 100% stock portfolio.
Why diversification works
In 2022, stocks fell 20%, but bonds and gold maintained value. A diversified portfolio lost less and returned to norm faster. Diversification doesn't eliminate losses — it softens them.
MPT criticism
- Assumes investor rationality — in practice emotions dominate
- Risk ≠ volatility — long-term investor doesn't fear volatility
- Correlations change — in crisis all assets fall simultaneously
- Historical data ≠ future — optimal proportions from the past may not work
What MPT means for you
- Diversify — don't keep everything in one asset class
- Think about portfolio as whole — one risky investment isn't a problem if the rest of the portfolio is stable
- Match risk to yourself — more stocks = higher return, but higher volatility
- Rebalance regularly — maintain target proportions
How Freenance can help
Freenance shows portfolio allocation and helps assess if it's appropriately diversified. The dashboard visualizes asset structure, making rebalancing decisions according to MPT principles easier.
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