When developing your portfolio, your financial advisor likely uses modern portfolio theory to help you choose the right assets and investment opportunities for your goals. However, this landmark theory in economics is often not explained to investors themselves. Understanding modern portfolio theory and how it has evolved into modern finance models can help you improve your financial prowess and put you on a more even playing field with your financial advisors. 


Modern portfolio theory boils down the relationship between assets and their risks into a formula your financial advisor can use to maximize return for your risk tolerance. In this guide, we’ll explore the history of modern portfolio theory and help you use it when selecting your next investment. 



Harry Markowitz and the Development of Modern Portfolio Theory


Harry Markowitz is a renowned economist who developed Modern Portfolio Theory (MPT) in the early 1950s. When working on his doctoral dissertation at the University of Chicago, he published some of his work in the Journal of Finance which would later mark the beginning of MPT research in the finance industry. Over several decades, his work refined what we know as modern portfolio theory today, and in 1990 he won the Nobel Prize in Economics for his work.


Today, economists and investors use the MPT and Markowitz Efficient Frontier to calculate portfolios that will offer the highest return for given risk tolerance. This takes much of the guesswork out for investors and helps brokerage and investment firms 


Fundamentals of MPT


Diversification comes second nature to most investors, especially as they expand into commercial real estate. Modern portfolio theory takes a closer look at diversification and condenses it into a formula you can use to determine the ideal relationship between assets that will give you the highest return for a certain level of risk. Investors must look at the mean-variance characteristics of their assets to determine this balance.


Using MPT, investors can reduce the amount of risk required to reach their given financial goals. While this does not reduce macro-risks at the market or global economic level, it can bolster your portfolio against idiosyncratic risks associated with different real estate holdings, stocks, and other assets in a given portfolio. 


Markowitz’ modern portfolio theory places equal importance on positive and negative risk, assuming that investors are equally interested in gains as they are avoiding losses. However, researchers since him have refined MPT to place heavier importance on loss aversion. This adjustment, known as post-modern portfolio theory, more accurately reflects the average investor’s heightened concern of losing money as opposed to making more. 


Modern portfolio theory helps shape your portfolio and ensure it performs maximally for your given risk tolerance and goals for your stage in life. If you’re interested in learning how modern portfolio theory plays in commercial real estate investing visit our Resource Center for more information.