Modern Portfolio Theory: A complete guide | Motilal Oswal

Modern Portfolio Theory: A complete guide


There are two facets of investment – risks and returns. Whenever you invest in an instrument, you take a certain level of risk to get returns in a specific range. Generally, the higher the risk, the larger the potential returns. However, not everyone has the same risk appetite. While aggressive investors tend to take high risks to get more returns, conservative investors are happy to get lower returns with minimum or no risk.

But as an investor, how would you know how much risk you need to take to achieve your financial goals? This is where the Modern Portfolio Theory (MPT) can aid you. Since its introduction in 1952, the MPT has become a crucial tool for investors and asset managers to create robust portfolios for adequate returns.

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Continue reading to learn what MPT is and how to implement it while building your investment portfolio.

What is modern portfolio theory?

Simply put, modern portfolio theory is an investment strategy that allows you to get maximum returns with a certain level of risk. Harry Markowitz, an American economist, developed this theory in 1952.

As per market experts, modern portfolio theory can be of great help in today’s time when the markets are highly volatile. With the help of this theory, you can achieve your long-term financial goals by avoiding the impact of emotions on your investment actions. 

How does modern portfolio theory work?

The modern portfolio theory works on two fundamental assumptions:

  1. You should never view investments in your portfolio in isolation. Instead, you need to look at them as a whole to understand the level of risk each investment carries and the potential return it can provide. Then, you can compare and figure out investments that haven’t met your expectations.
  2. It’s almost impossible to predict future market movements. Hence, you should look at the long-term historical performance of an asset to get an idea of the approximate returns you can generate by investing in it. 

Keeping these two fundamentals in mind, you need to proceed with your investment portfolio. Based on your precise risk appetite, you need to create a diversified portfolio of varying securities and asset classes suited to your long-term financial goals. The MPT emphasizes the importance of diversification to spread the risks in investment portfolios. The idea is to create a well-balanced portfolio such that the overall risk-return ratio is as per your risk appetite and investment goals respectively.

How do you achieve this?

Now that you know about the modern portfolio theory, the question is how you can use it in your real life. Let’s understand this with the help of a few examples.

There are two methods to achieve a well-balanced portfolio as suggested under the MPT. These are the strategic asset allocation and the two-fund theorem. In the first method, you need to create a smart portfolio so that your investments are not in direct correlation with each other.

For example, equity shares are risky instruments as compared to bonds. So, you should include both shares and bonds in your investment portfolio. So, even if the value of shares in your portfolio declines during bearish markets, that of bonds will increase. As per the MPT, both will balance out each other, and your portfolio will continue to yield the desired returns.

Now, in the second method, you need to add two funds to your portfolio. One should be equity-based, and the other should be debt-based. Following the MPT, this strategy will minimize your loss even if any of the funds in your portfolio performs poorly. The allocation of the funds will depend on your investment goals and how far you are from achieving them. 

For instance, if you plan to achieve your goal in 10 years, make around 70% investment in an equity fund and the remaining 30% in a debt fund. Reverse this allocation once you are close to your goal.

To conclude

If you are an amateur investor, you can benefit immensely from the modern portfolio theory. It allows you to create a well-balanced portfolio without taking too much of risks on the returns. However, remember that this theory is based on certain assumptions and may not work during unfavorable market conditions.

In the world of investment, what matters the most is your expertise, experience, and ability to speculate. If you need expert guidance on stock market investing, you can take the help of Motilal Oswal.


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