{"id":919,"date":"2020-08-04T23:22:51","date_gmt":"2020-08-04T23:22:51","guid":{"rendered":"http:\/\/algotrading101.com\/wiki\/?p=919"},"modified":"2020-08-04T23:22:52","modified_gmt":"2020-08-04T23:22:52","slug":"what-is-modern-portfolio-theory","status":"publish","type":"post","link":"https:\/\/algotrading101.com\/wiki\/what-is-modern-portfolio-theory\/","title":{"rendered":"What is Modern Portfolio Theory?"},"content":{"rendered":"\n<figure class=\"wp-block-image size-large is-resized\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/MPT.jpg\" alt=\"Modern Portfolio Theory (MPT)\" class=\"wp-image-920\" width=\"543\" height=\"768\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/MPT.jpg 543w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/MPT-212x300.jpg 212w\" sizes=\"auto, (max-width: 543px) 100vw, 543px\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\">Modern Portfolio Theory (MPT) is a method to select which stocks and what amounts to buy such that as a group, these stocks give the highest amount of returns for a given amount of risk.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">In this article, risk is defined as the volatility[2] of your returns[1].<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">[1] Returns are the money made or lost over a period of time.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">[2] Volatility refers to returns that change rapidly and unexpectedly.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Understanding Modern Portfolio Theory<\/h2>\n\n\n\n<p class=\"wp-block-paragraph\">The 2 main ideas behind MPT are:<\/p>\n\n\n\n<ol class=\"wp-block-list\"><li>Preference for higher reward per risk<\/li><li>Risk cancellation<\/li><\/ol>\n\n\n\n<h3 class=\"wp-block-heading\"><strong>Preference for higher reward per risk<\/strong><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\">Let&#8217;s say you are betting at a casino and you have 2 games to choose from.<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>In the first game, you gain $5 if you win. But if you lose, you&#8217;re out $3.<\/li><li>In the second, you could win $5, but if you lose, you are down $1.<\/li><\/ul>\n\n\n\n<p class=\"wp-block-paragraph\">Assume that the odds of winning is the same for both games.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Which will you choose? <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">I hope you choose the second game. If you chose the first, please go ahead and close your trading account now.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">This shows that for a given set of returns, we naturally want to risk as little as possible.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Similarly, if we were to compare 2 stocks with the same gain, we prefer the one with less volatility.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"597\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Returns-vs-risk-1024x597.png\" alt=\"Returns vs risks. Chart of 2 stocks. One is more volatile than the other but the overall returns are the same.\" class=\"wp-image-896\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Returns-vs-risk-1024x597.png 1024w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Returns-vs-risk-300x175.png 300w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Returns-vs-risk-768x448.png 768w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Returns-vs-risk-1536x896.png 1536w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Returns-vs-risk.png 1590w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><figcaption>Chart style inspired by xkcd.com<\/figcaption><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\">We prefer Stock X!<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><strong>Risk cancellation<\/strong><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\">Let&#8217;s talk about stocks now. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">To understand risk cancellation, we look at 2 stocks. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Stock A looks like this:<\/strong><\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"675\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-A-1024x675.png\" alt=\"Stock price chart\" class=\"wp-image-892\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-A-1024x675.png 1024w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-A-300x198.png 300w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-A-768x506.png 768w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-A.png 1069w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Stock B looks like this:<\/strong><\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"651\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-B-1024x651.png\" alt=\"Stock price chart\" class=\"wp-image-893\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-B-1024x651.png 1024w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-B-300x191.png 300w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-B-768x488.png 768w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Stock-B.png 1108w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\">Both Stock A and B look similar. They both move up. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">However, there is a difference, they are inversely correlated in the short run.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Combining Stock A and B<\/strong><\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"605\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Modern-Portfolio-Theory-1024x605.png\" alt=\"Short-term inversely correlated stock price chart\" class=\"wp-image-897\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Modern-Portfolio-Theory-1024x605.png 1024w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Modern-Portfolio-Theory-300x177.png 300w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Modern-Portfolio-Theory-768x454.png 768w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Modern-Portfolio-Theory.png 1169w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\">Both Stock A and B moves up at the same rate (i.e. have the same returns). <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">However, their short term moves cancel out. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">As an example, if we own $50 of Stock A and $50 of Stock B, our $100 total investment can be represented by the red line.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The red line is better than owning $100 of either Stock A or Stock B alone as it is less volatile. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Remember we want the highest returns per risk (where risk is defined as the volatility of return).<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><strong>So, what is MPT really?<\/strong><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\">MPT tells us to choose stocks in a way that their risks cancel out and that the overall returns are the highest for the amount of risk we take on.<\/p>\n\n\n\n<h3 class=\"wp-block-heading\">Increasing stocks to cancel out more risks<\/h3>\n\n\n\n<p class=\"wp-block-paragraph\">One more concept of MPT is the required number of stocks for risk cancellation.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Using 2 stocks to cancel risks might not be ideal as it is difficult for the 2 stocks to be inversely correlated (in the short term) all the time. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If we have 3 stocks, it would be easier. If we have 4, it&#8217;s even easier. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">However, each stock addition reduces risks to a lesser extent. The reason is, as our overall risk declines, there isn&#8217;t much risk left to eliminate.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Legendary hedge fund manager Ray Dalio describes this better than me: <a href=\"https:\/\/www.youtube.com\/watch?v=Nu4lHaSh7D4\" target=\"_blank\" aria-label=\"undefined (opens in a new tab)\" rel=\"noreferrer noopener\">Ray Dalio breaks down his &#8220;Holy Grail&#8221;<\/a><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">A key takeaway from the video: Once you have about 10 assets in your portfolio, every additional asset provides minimal risk reduction.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">One thing to note &#8211; when the risks to any individual stock are minimized, the main risk that is left is the exposure to the overall market movement.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Note that we use stocks in our examples but MPT applies to any asset &#8211; Commodities, Fixed Income, Forex, Cryptocurrency, etc.<\/em><\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Why is MPT important to you?<\/h2>\n\n\n\n<p class=\"wp-block-paragraph\">3 reasons.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Being able to size up to make more profits!<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If your portfolio has low volatility, you will be able to increase your bet size without fear of losing it all.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Here is what happens when you double the amount you trade when your portfolio is volatile.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"649\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-1024x649.png\" alt=\"\" class=\"wp-image-908\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-1024x649.png 1024w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-300x190.png 300w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-768x486.png 768w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-1536x973.png 1536w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing.png 1601w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\">You hit $0 and get wiped out.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Here is what happens when you double the amount you trade when your portfolio is less volatile.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"668\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-3-1-1024x668.png\" alt=\"\" class=\"wp-image-910\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-3-1-1024x668.png 1024w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-3-1-300x196.png 300w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-3-1-768x501.png 768w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-3-1-1536x1002.png 1536w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2020\/08\/Position-sizing-3-1.png 1566w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\">You stay in the game and make more monies!<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Staying in the game<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Even if your account does not hit zero. You might be in an unrecoverable position.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If you lose 50% need to make 100% to recover.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If your portfolio is worth $100 and you lose $90, you&#8217;ll only have $10 left. You need to make 1000% to hit $100 again.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Thus, if your returns are too volatile, you might not be able to recover.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Examples of Modern Portfolio Theory<\/h2>\n\n\n\n<p class=\"wp-block-paragraph\">Modern Portfolio theory has inspired certain specific portfolios such as the <a aria-label=\"undefined (opens in a new tab)\" href=\"http:\/\/www.lazyportfolioetf.com\/allocation\/ray-dalio-all-weather\/\" target=\"_blank\" rel=\"noreferrer noopener\">Ray Dalio All Weather Portfolio<\/a>.<\/p>\n\n\n\n<hr class=\"wp-block-separator\"\/>\n","protected":false},"excerpt":{"rendered":"<p>Modern Portfolio Theory (MPT) is a method to select which stocks and what amounts to buy such that as a group, these stocks give the highest amount of returns for a given amount of risk. In this article, risk is defined as the volatility[2] of your returns[1]. [1] Returns are the money made or lost [&hellip;]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_links_to":"","_links_to_target":"","footnotes":""},"categories":[2],"tags":[],"class_list":["post-919","post","type-post","status-publish","format-standard","hentry","category-finance-resources"],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v28.7 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>What is Modern Portfolio Theory? 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