Modern portfolio theory (MPT) is a framework that combines logical assumptions and statistical data, to help investors create portfolios. Modern portfolio theory calculations work to eliminate the psychology and guesswork from deciding which investments to buy. MPT is a controversial idea that has drawn sharp criticism.
Modern portfolio theory assumes that investors want investments that offer the highest potential gain for the least amount of risk. MPT does not attempt to beat the market by analyzing and trading individual investments. Modern portfolio theory argues that investments are already fairly priced because of the high level of competition within financial markets. In general, assets cannot be described as overvalued or undervalued. MPT differs from fundamental analysis, where investors evaluate financial data from corporate annual reports to buy undervalued or cheap investments.
MPT calculations design portolios with expected returns based upon probability. The calculations compare historical average returns against deviation for major asset classes, such as stocks and bonds. Deviation measures the difference from average returns--during any given time period. Risky assets feature higher deviations. For example, the Standard and Poor's Index 500 (S&P 500) is a benchmark for United States stock market activity that has averaged 11 percent annual returns since its 1957 inception. Eleven percent is the average figure for volatile returns that include 38 percent gains in 1995 and 37 percent losses in 2008.
Online tools and financial planning software, such as Quicken, can help you design your portfolio according to MPT guidelines. These tools require you to complete questionnaires regarding your current income, expenses, assets, age and financial goals. Common financial goals include providing for education funding, retirement income, and your first-time home purchase. The software analyzes your information, and recommends a diversified portfolio that lists out stocks, bonds, and cash reserves as percentages. Mutual funds provide exposure to each distinct asset class. Morningstar is a good online resource to design portfolios and select mutual funds that manage risks while providing for potential growth.
Do not assume that your recommended portfolio will remain the same throughout your life cycle. For example, younger savers have more time to recover from potential losses, and are better served with higher exposure to the stock market. At the other extreme, heavier bond market exposure offers stable returns that are more suitable for retirees. Review your portfolio two times per year to account for any lifestyle changes, such as promotions, marriage and childbirth.
MPT assumes that assets are fairly valued, or priced correctly. MPT detractors, however, point to sharp stock market crashes as evidence that assets rarely trade at fair value. Fairly valued assets would not be prone to sharp declines of at least ten percent in one day. Further, the records of skilled investors, such as Warren Buffett, prove that it is possible to beat the market through fundamental economic research, rather than merely relying upon historical return data and probabilities.