======Modern Portfolio Theory (MPT)======
Modern Portfolio Theory (MPT) is a mathematical framework for assembling a portfolio of assets. Developed by economist [[Harry Markowitz]] in the 1950s, for which he later won a Nobel Prize, its central idea is that an investor can maximize their portfolio's [[return]] for a given level of [[risk]]. The magic isn't in picking individual "winners" but in how the assets work together. MPT formalizes the concept of [[diversification]], demonstrating that owning a mix of assets whose prices don't move in perfect lockstep can reduce overall portfolio risk more effectively than owning assets that are highly similar. It achieves this by analyzing each asset's [[expected return]], its [[volatility]] (a measure of risk), and its [[correlation]] (how its returns move in relation to other assets). While academically profound, MPT's reliance on historical data and its definition of risk as price volatility often puts it at odds with the core tenets of [[value investing]].
===== The Core Idea: Don't Put All Your Eggs in One Basket =====
We've all heard the old saying about eggs and baskets. MPT gives this wisdom a powerful mathematical backbone. It argues that the riskiness of a portfolio should be judged not by the risk of its individual assets, but by how they contribute to the //overall// portfolio's risk.
The key ingredient is **correlation**. Imagine an umbrella salesman who decides to also sell ice cream. On rainy days, umbrella sales are great, but no one wants ice cream. On sunny days, the opposite is true. While each business line is volatile on its own, the combined business has much more stable, predictable revenue. This is the power of owning assets with low or negative correlation.
  * **Positive Correlation:** The assets tend to move in the same direction. Example: Two large oil companies. When oil prices rise, both their stocks likely go up. This offers little diversification benefit.
  * **Negative Correlation:** The assets move in opposite directions (the holy grail, but rare). Example: The umbrella and ice cream businesses.
  * **Low/No Correlation:** The assets' price movements are largely unrelated. This is the practical goal for building a robust portfolio. For instance, a tech stock and a consumer staples company may not have much to do with each other.
By combining assets with low correlations, MPT shows you can build a portfolio that has a lower overall risk than the simple weighted average of the individual assets' risks.
===== The Efficient Frontier: The 'Best' Portfolios =====
So how do you find the perfect mix? MPT introduces a concept called the [[Efficient Frontier]].
Picture a graph where the vertical axis is expected return and the horizontal axis is risk (typically measured by [[standard deviation]] of returns). The Efficient Frontier is a curve that represents the set of "optimal" portfolios. For any given level of risk you're willing to take, there is a portfolio on the frontier that offers the highest possible expected return. Any portfolio that lies //below// the curve is "sub-optimal" because you could either get a higher return for the same risk or the same return for less risk.
To plot this frontier, you need to input three data points for every asset you're considering: its expected return, its volatility, and its [[correlation coefficients]] with every other asset in the portfolio. By adding a [[risk-free asset]] (like a [[government bond]]) into the mix, investors can then create portfolios along the [[Capital Allocation Line]] (CAL), which represents an even better set of risk-return trade-offs than the frontier alone.
===== MPT from a Value Investing Perspective =====
While MPT is a cornerstone of modern finance, a true value investor, in the vein of [[Benjamin Graham]] or [[Warren Buffett]], would view it with healthy skepticism. The philosophies clash on several fundamental points.
==== Defining Risk ====
MPT's biggest weakness, from a value investor's perspective, is its definition of risk. MPT equates risk with **volatility**—the ups and downs of a stock price.
For a value investor, risk is not price fluctuation; it is the **permanent loss of capital**. A sharp drop in the price of a wonderful business isn't a risk; it's an //opportunity// to buy more at a cheaper price. Volatility can be your friend. The real risks are buying a mediocre business, overpaying for a good one, or suffering a permanent impairment of the company's underlying earning power.
==== Predictability vs. Uncertainty ====
MPT relies on historical data—past returns, past volatility, and past correlations—to model the future. Value investors argue that the future is fundamentally uncertain and unpredictable. As [[Charlie Munger]] notes, using historical volatility to manage risk is like "driving a car by looking in the rearview mirror." A value investor's risk management tool is not a spreadsheet of correlations but a deep understanding of the business and purchasing it with a significant [[margin of safety]].
==== Diversification vs. Concentration ====
MPT champions broad diversification to smooth out returns. While value investors agree that some diversification is prudent, they often favor concentration. Buffett famously stated that "diversification is protection against ignorance. It makes very little sense if you know what you're doing." Why put your 20th-best idea into your portfolio instead of adding more to your best idea? For a value investor, true safety comes from knowing your few investments inside and out, not from owning a little bit of everything. Owning too many things can lead to what Peter Lynch called "diworsification."
===== The Verdict =====
Modern Portfolio Theory was a revolutionary idea that forced the investment world to think more scientifically about risk and portfolio construction. Its principles underpin many mainstream investment products today, from [[index funds]] to [[robo-advisors]]. It provides a useful vocabulary and a framework for understanding how assets interact.
However, for the investor focused on buying great businesses at fair prices, MPT's assumptions can be dangerously misleading. Its definition of risk is flawed, it relies on an unpredictable future mirroring the past, and it can lead to a false sense of security through over-diversification. A savvy investor should understand the concepts of MPT but build their portfolio based on the enduring value investing principles of business analysis, a margin of safety, and defining risk on their own terms.