Modern Portfolio Theory (MPT)
Combine assets that do not move together, and risk falls faster than return.
Modern Portfolio Theory (MPT) says investors should judge an investment by what it does to the risk and return of the whole portfolio, not on its own. Because assets do not move in perfect step, combining them can cut risk without cutting expected return in the same proportion. Harry Markowitz set out the idea in 1952.
For a PMS distributor, MPT is the reasoning behind diversification, asset allocation and rebalancing. The XXI-A curriculum does not name it as a heading, but its chapters on diversification and on correlation across asset classes are built on it.
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The core ideas
- Expected return
- The weighted average of the expected returns of the holdings. Combining assets never changes this arithmetic.
- Risk (standard deviation)
- How widely returns swing around their average. MPT measures risk this way.
- Correlation
- How two assets move together, from +1 (always in step) through 0 (unrelated) to −1 (always opposite). The lower the correlation, the more risk diversification removes.
- Diversifiable (unsystematic) risk
- Risk specific to one company or sector. Adding more varied holdings reduces it.
- Systematic (market) risk
- Risk that hits the whole market, such as an economic slowdown. Diversification cannot remove it.
- Efficient frontier
- The set of portfolios giving the highest expected return for each level of risk. Any portfolio below the line is inefficient: another mix gives more return for the same risk.
Worked example: correlation does the work
Illustrative figures, not forecasts. A 50:50 mix of an equity portfolio (expected return 12%, standard deviation 20%) and a debt portfolio (expected return 7%, standard deviation 8%).
+1.0 (move in step)
Expected return of the mix
9.5%
Risk of the mix
14.0%, the simple average: no benefit
+0.2
Expected return of the mix
9.5%
Risk of the mix
About 11.5%
−0.5
Expected return of the mix
9.5%
Risk of the mix
About 8.7%
| Correlation between the two | Expected return of the mix | Risk of the mix |
|---|---|---|
| +1.0 (move in step) | 9.5% | 14.0%, the simple average: no benefit |
| +0.2 | 9.5% | About 11.5% |
| −0.5 | 9.5% | About 8.7% |
Reading the example
Return stays at 9.5% in every row, because it is a plain weighted average. Risk falls as correlation falls, because the swings of one asset partly cancel the other's. That gap between 14% and the lower figures is the benefit of diversification.
The formula behind the risk column is the two-asset portfolio variance: weight squared times variance for each asset, plus twice the product of the weights, the two standard deviations and the correlation. Exams rarely ask for the full calculation; they ask which way risk moves when correlation changes.
Free account, this exam preselected.
Assumptions and limits
- check_circleInvestors are assumed to be risk averse: for the same return they choose the lower risk.
- check_circleRisk is treated as standard deviation, which counts upside swings as risk too.
- check_circleExpected returns, risks and correlations must be estimated, and estimates can be wrong. Correlations often rise in a crisis, just when diversification is needed.
- check_circleReturns are assumed to follow a normal distribution, which understates the chance of extreme falls.
Why a PMS client should care
A concentrated PMS portfolio of a few stocks in one market still carries market risk, and may carry sector risk if the stocks are similar. MPT is the case for looking at a client's whole wealth, including their other funds, property and deposits, before adding a concentrated equity mandate.
How XXI-A tests this
Expect concept MCQs on a 100-mark paper with a 60% pass mark: what happens to portfolio risk when correlation falls, which risk diversification cannot remove, or what lies on the efficient frontier.
The traps: claiming diversification raises return (it reduces risk for the return), claiming it removes all risk (systematic risk stays), and treating correlation of +1 as helpful.
FAQs
What is modern portfolio theory in simple words?expand_more
Judge each investment by how it changes the whole portfolio's risk and return. Mixing assets that do not move together lowers risk for a given expected return.
Who developed modern portfolio theory?expand_more
Harry Markowitz, in a 1952 paper on portfolio selection.
What is the efficient frontier?expand_more
The curve of portfolios that give the highest expected return for each level of risk. Rational, risk-averse investors choose a point on it.
Does diversification remove all risk?expand_more
No. It removes risk specific to a company or sector, but market-wide (systematic) risk remains.
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