Modern Portfolio Theory (MPT)

Modern Portfolio Theory, developed by Harry Markowitz in 1952, revolutionized investment management by providing a mathematical framework for constructing portfolios that optimize the trade-off between risk and return.

Core Principles of MPT

The Risk-Return Trade-off

MPT established several fundamental investment principles:

• Higher returns require higher risk: Investors must accept more volatility to achieve greater expected returns
• Investors are risk-averse: Given equal returns, rational investors prefer less risk
• Diversification reduces risk: Combining assets can lower portfolio volatility without necessarily reducing expected returns

The Key Insight

Portfolio risk is NOT simply the weighted average of individual security risks.

Instead, portfolio risk depends critically on the correlations (covariances) between assets. This insight is the foundation of diversification benefits.

Correlation and Diversification

Understanding Correlation Coefficient (ρ)

The correlation coefficient measures how two assets move in relation to each other:

Real-World Correlation Examples

Key Point: Even positively correlated assets (correlation < +1) provide SOME diversification benefit.

The Efficient Frontier

Definition

The efficient frontier is the set of optimal portfolios that:

• Offer the highest expected return for a given level of risk, OR
• Offer the lowest risk for a given expected return

Visualizing the Efficient Frontier

Imagine plotting all possible portfolios on a graph with:

• X-axis: Risk (standard deviation)
• Y-axis: Expected return

The efficient frontier is the curved line representing optimal portfolios.

Portfolio Positions Relative to the Frontier

Types of Risk

MPT distinguishes between two types of risk:

Systematic Risk (Market Risk)

• Affects the entire market
• Cannot be diversified away
• Examples: Interest rate changes, inflation, recession, political events
• Measured by beta

Unsystematic Risk (Company-Specific Risk)

• Affects individual securities or sectors
• Can be diversified away
• Examples: CEO resignation, product recall, labor strike
• Reduced by holding 20-30+ different securities

Standard Deviation

Definition and Interpretation

Standard deviation measures the dispersion of returns around the average (mean):

The Normal Distribution Rule

For normally distributed returns:

• 68% of returns fall within ±1 standard deviation
• 95% of returns fall within ±2 standard deviations
• 99.7% of returns fall within ±3 standard deviations

Example: If a fund has average return of 10% and standard deviation of 15%:

• 68% of returns between -5% and +25%
• 95% of returns between -20% and +40%

The Capital Market Line (CML)

When a risk-free asset is added to the investment universe, the efficient frontier becomes a straight line called the Capital Market Line.

CML Key Points

• Starts at the risk-free rate (where risk = 0)
• Tangent to the efficient frontier at the "market portfolio"
• All investors should hold some combination of the risk-free asset and the market portfolio
• Slope of CML = Market's Sharpe Ratio

In Practice

Investment advisers apply MPT by:

• Building diversified portfolios across asset classes with low correlations
• Selecting the portfolio on the efficient frontier that matches client risk tolerance
• Recognizing that most risk reduction comes from the first 20-30 securities
• Understanding that international diversification adds value due to lower correlations

On the Exam

Series 65 frequently tests:

• The relationship between correlation and diversification benefits
• Systematic vs. unsystematic risk (which can be diversified)
• Standard deviation as a measure of total risk
• The concept of the efficient frontier

Key Takeaways

1. MPT shows portfolio risk depends on correlations, not just individual security risks
2. Lower correlation = greater diversification benefit
3. Systematic risk CANNOT be diversified; unsystematic risk CAN be diversified
4. Efficient frontier portfolios offer optimal risk/return combinations
5. Standard deviation measures total volatility of returns
6. Adding a risk-free asset creates the Capital Market Line