Modern portfolio theory, or MPT was developed in the 1950s by economist Harry Markowitz. It describes in mathematical models the relationships between risk and return in investing, and it names diversification as the best way to make the most of your investing dollars. Immensely influential throughout the second half of the 20th century, it has been one of the factors in the tremendous success of mutual funds.
According to modern portfolio theory, risk versus return should be looked at across the whole of an investor’s portfolio rather than considered only in the context of each individual investment. MPT posits that holding a diverse portfolio can actually insulate the investor from some of the risks inherent in each individual stock, thus reducing overall risk.
The difficulty with implementing MPT for the average individual investor would seem to be the amount of time and expertise involved in truly diversifying a portfolio. This is where mutual funds come in. Any mutual fund may contain dozens -- even hundreds -- of stocks or bonds carefully picked by a professional fund manager. Buying mutual funds has thus been recognized as one way for a non-professional investor to easily reap the benefits of MPT.
MPT has many detractors and has been increasingly criticized in the wake of the 2008 market crash. Some critics charge that what the theory actually measures is volatility rather than risk. Volatility is not exclusively bad -- it includes the upward movement of stocks -- and therefore, critics say, MPT’s mathematical models give skewed results.
Mutual funds sometimes exact a high price for the diversification they provide. MPT does not take account of mutual fund fee structures, which can be a very significant concern for investors who choose to diversify this way. Fees can affect overall returns by several percentage points, again skewing the risk/return equation on which investors might rely.
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