Discussing Modern Portfolio Theory

April 25, 20238 min read
Discussing Modern Portfolio Theory
Share on facebookShare on TwitterShare on Linkedin

Key Takeaways

  • Modern Portfolio Theory (MPT) is a framework that enables investors to optimize their portfolios based on their risk tolerance and expected return.
  • In any discussion regarding Modern Portfolio Theory (MPT), the foundational concepts of risk, return, and diversification need to be thoroughly explored.
  • One of the key benefits of MPT is that it offers a quantifiable measure of portfolio risk.

Modern Portfolio Theory (MPT) is a critical financial concept that has revolutionized investment strategies since its inception. Originally introduced by Harry Markowitz in the 1950s, it has become a cornerstone of investment risk management, advocating for diversified portfolios as a means to optimize returns. The concept received a Nobel prize, underscoring its significant impact on financial theory and practice.

MPT is a framework that enables investors to optimize their portfolios based on their risk tolerance and expected return. It postulates that the risk and return of a portfolio are not merely an aggregate of the individual securities, but also depend on the correlation among those securities. This theory empowers investors to make informed decisions and has profound implications for asset allocation.

Core Components of Modern Portfolio Theory

In any discussion regarding Modern Portfolio Theory (MPT), the foundational concepts of risk, return, and diversification need to be thoroughly explored. These components underpin the theory’s core tenets, guiding how portfolios should be constructed and managed for optimal performance.

Risk and Return

Risk and return form a symbiotic relationship within MPT. Risk, often quantified by the standard deviation of returns, denotes the potential for financial loss. It is the level of uncertainty about the returns an investment may yield. High standard deviation implies that the return on an investment may significantly vary, indicating higher volatility and, therefore, higher risk.

Return, conversely, is the profit or loss made on an investment over a certain period. In essence, it’s the reward for taking on investment risk. Typically measured as a percentage, the return on investment is the degree to which the investment’s value has grown or diminished over time.

In MPT, the pivotal relationship between risk and return is that they are directly proportional. The potential for higher returns usually comes with increased risk. Conversely, lower risk investments generally yield lower returns. This risk-return tradeoff is at the heart of MPT’s asset allocation guidance. The challenge for any investor is to find the optimal balance between risk and return that aligns with their specific financial goals and risk tolerance.

Diversification and Correlation

Another core component of MPT is diversification, underpinned by the correlation among different assets. Correlation, in this context, measures the degree to which the returns of two assets move in relation to each other.

If two assets are perfectly correlated (correlation coefficient +1), their prices move in perfect sync. This means if one asset’s price increases, the other’s price also increases, and vice versa. On the other hand, if two assets have a perfect negative correlation (correlation coefficient -1), their prices move in opposite directions. When the price of one asset increases, the price of the other decreases, and so forth.

In a diversified portfolio, the aim is to include a mix of assets that are not perfectly correlated. The rationale behind this is that when some assets are down, others might be up. This lack of perfect correlation can reduce the portfolio’s overall risk. In other words, the negative performance of some investments may be offset by the positive performance of others, leading to more stable overall portfolio returns.

Correlation and diversification are inherently linked in MPT. Diversification isn’t simply about increasing the number of different assets in a portfolio but strategically choosing a mix of assets based on their correlation. The aim is to reduce overall portfolio risk without significantly diminishing expected returns. Diversification, therefore, serves as a practical risk management tool, offering investors the opportunity to mitigate potential losses and optimize returns.

Benefits of Modern Portfolio Theory

One of the key benefits of MPT is that it offers a quantifiable measure of portfolio risk. By considering the interaction between different assets, rather than assessing each in isolation, it provides a holistic view of portfolio risk.

MPT also guides investors in asset allocation. It encourages investment in a mix of asset classes, including public equities, fixed income products, real estate, and other alternative investments, based on the investor’s risk aversion and return expectations.

Moreover, MPT introduced the concept of an efficient frontier. This frontier represents the set of portfolios that offer the highest expected return for a given level of risk or, conversely, the lowest risk for a given level of return.

Real-World Application of Modern Portfolio Theory

Imagine an investor named Sophia, an enthusiast of the vibrant art scene. Sophia is considering investing in a boutique art gallery located in a trendy neighborhood known for its artistic charm. She is captivated by the gallery’s potential for steady rental income and the prospect of the property’s appreciation due to the neighborhood’s rising popularity. Yet, she recognizes the risks involved: the local property market might fluctuate, the demand for art can be fickle, and selling such a unique piece of real estate might prove challenging if she ever needed to liquidate her investment.

Here’s where the application of Modern Portfolio Theory becomes particularly useful. To manage these risks and enhance potential returns, Sophia doesn’t limit her investment horizon to the art gallery alone. Instead, she looks to build a diversified portfolio, adding different types of assets.

She considers investing in publicly traded stocks of technology firms whose innovative solutions are disrupting their respective industries. Sophia also looks into fixed income products like corporate bonds issued by established, blue-chip companies, which could provide steady income with lower risk.

On top of that, she explores other alternative investments. Sophia looks into mutual funds focusing on green technologies, seeing an opportunity in the global trend towards sustainability.

By doing so, Sophia applies the principles of Modern Portfolio Theory. She builds a portfolio that includes the art gallery (real estate), public equities (technology stocks), fixed income products (corporate bonds), and other alternative investments (green technology mutual funds). The lack of perfect correlation between these assets allows Sophia to reduce her overall risk exposure. If the art gallery’s value dips due to a slump in the local art scene, this loss might be offset by gains in her technology stocks or the steady income from her corporate bonds.

In this way, MPT’s principles guide Sophia in constructing a diversified portfolio that aligns with her risk tolerance and return expectations, potentially improving her portfolio’s overall risk-return trade-off. Through this real-world example, the practicality and usefulness of Modern Portfolio Theory become clear.

Limitations and Criticisms of Modern Portfolio Theory

Despite its profound influence, MPT is not without its critics. Some argue that MPT relies heavily on historical data, which may not predict future market behavior. It also assumes that investors are rational and that markets are efficient, assumptions often challenged by behavioral finance studies.

MPT’s risk measure, standard deviation, considers both upward and downward price movements as risky, which may not align with an investor’s perspective who welcomes upward volatility.

Modern Portfolio Theory vs. Post-Modern Portfolio Theory

Both Modern Portfolio Theory (MPT) and Post-Modern Portfolio Theory (PMPT) play essential roles in shaping investment strategies, yet their approach towards risk, return, and portfolio construction notably differs.

Approach to Risk

MPT considers risk as the standard deviation of portfolio returns. In essence, it views both upside (positive) and downside (negative) price changes as risky since they contribute to volatility. This perspective can be at odds with many investors’ instincts, who typically welcome positive price changes and view only downside volatility as a true risk.

PMPT, however, aligns more with this intuitive investor perspective. It dismisses the idea that all volatility is risk. Instead, it defines risk as downside volatility or downside deviation. This means only negative returns, which lead to losses, are deemed risky. This approach can be more meaningful to investors as it focuses on the risk of losses, which is their primary concern.

Incorporation of Skewness and Kurtosis

While MPT bases its risk-assessment on an assumption of normally distributed returns, in reality, investment returns often display skewness and kurtosis, deviating from this assumption.

Skewness measures the asymmetry of a distribution. A negatively skewed distribution has a long left tail, indicating a higher probability of negative returns, while a positively skewed distribution indicates a higher chance of positive returns.

Kurtosis, on the other hand, measures the “tailedness” of a distribution. High kurtosis signifies a higher probability of extreme positive or negative returns (fat tails), while low kurtosis indicates a lower probability of extreme returns (thin tails).

PMPT introduces these two concepts to provide a more nuanced picture of risk. It acknowledges that returns are not always symmetrically distributed and that outliers (or extreme events) can significantly impact a portfolio. By accounting for skewness and kurtosis, PMPT provides a potentially more complete understanding of the risk landscape, allowing for a more thorough risk assessment.

Modern Portfolio Theory and Diversification

MPT’s central message is the power of diversification. By investing in a combination of different asset classes, including traditional and alternative investments, one can construct a portfolio that maximizes expected return for a given level of risk. This is particularly relevant for investors seeking to build retirement income or short-term liquidity.

MPT serves as a reminder that diversification isn’t just about investing in different securities or sectors but about finding assets whose returns are not perfectly correlated. This potentially improves the risk-return trade-off and moves the portfolio closer to the efficient frontier.

Rise above Volatility

Diversify your portfolio with private market investment offerings.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Modern Portfolio Theory provides a valuable framework for understanding portfolio risk and return, guiding asset allocation, and leveraging the power of diversification. Despite its limitations and the emergence of alternative theories like PMPT, it remains a fundamental concept in investment management, offering insights to both novice and seasoned investors.

We believe our 10 alternative asset classes, track record across 470+ investments, third party reviews, and history of innovation makes Yieldstreet “The leading platform for private market investing,” as compared to other private market investment platforms.

1 Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections may not reflect actual future performance. All securities involve risk and may result in significant losses.

3 "Annual interest," "Annualized Return" or "Target Returns" represents a projected annual target rate of interest or annualized target return, and not returns or interest actually obtained by fund investors. “Term" represents the estimated term of the investment; the term of the fund is generally at the discretion of the fund’s manager, and may exceed the estimated term by a significant amount of time. Unless otherwise specified on the fund's offering page, target interest or returns are based on an analysis performed by Yieldstreet of the potential inflows and outflows related to the transactions in which the strategy or fund has engaged and/or is anticipated to engage in over the estimated term of the fund. There is no guarantee that targeted interest or returns will be realized or achieved or that an investment will be successful. Actual performance may deviate from these expectations materially, including due to market or economic factors, portfolio management decisions, modelling error, or other reasons.

4 Reflects the annualized distribution rate that is calculated by taking the most recent quarterly distribution approved by the Fund's Board of Directors and dividing it by prior quarter-end NAV and annualizing it. The Fund’s distribution may exceed its earnings. Therefore, a portion of the Fund’s distribution may be a return of the money you originally invested and represent a return of capital to you for tax purposes.

5 Represents the sum of the interest accrued in the statement period plus the interest paid in the statement period.

6 The internal rate of return ("IRR") represents an average net realized IRR with respect to all matured investments, excluding our Short Term Notes program, weighted by the investment size of each individual investment, made by private investment vehicles managed by YieldStreet Management, LLC from July 1, 2015 through and including July 18th, 2022, after deduction of management fees and all other expenses charged to investments.

7 Investors should carefully consider the investment objectives, risks, charges and expenses of the Yieldstreet Alternative Income Fund before investing. The prospectus for the Yieldstreet Alternative Income Fund contains this and other information about the Fund and can be obtained by emailing [email protected] or by referring to www.yieldstreetalternativeincomefund.com. The prospectus should be read carefully before investing in the Fund. Investments in the Fund are not bank deposits (and thus not insured by the FDIC or by any other federal governmental agency) and are not guaranteed by Yieldstreet or any other party.

8 This tool is for informational purposes only. You should not construe any information provided here as investment advice or a recommendation, endorsement or solicitation to buy any securities offered on Yieldstreet. Yieldstreet is not a fiduciary by virtue of any person's use of or access to this tool. The information provided here is of a general nature and does not address the circumstances of any particular individual or entity. You alone assume the sole responsibility of evaluating the merits and risks associated with the use of this information before making any decisions based on such information.

9 Statistics as of the most recent month end.

300 Park Avenue 15th Floor, New York, NY 10022

844-943-5378

No communication by YieldStreet Inc. or any of its affiliates (collectively, “Yieldstreet™”), through this website or any other medium, should be construed or is intended to be a recommendation to purchase, sell or hold any security or otherwise to be investment, tax, financial, accounting, legal, regulatory or compliance advice, except for specific investment advice that may be provided by YieldStreet Management, LLC pursuant to a written advisory agreement between such entity and the recipient. Nothing on this website is intended as an offer to extend credit, an offer to purchase or sell securities or a solicitation of any securities transaction.

Any financial projections or returns shown on the website are estimated predictions of performance only, are hypothetical, are not based on actual investment results and are not guarantees of future results. Estimated projections do not represent or guarantee the actual results of any transaction, and no representation is made that any transaction will, or is likely to, achieve results or profits similar to those shown. In addition, other financial metrics and calculations shown on the website (including amounts of principal and interest repaid) have not been independently verified or audited and may differ from the actual financial metrics and calculations for any investment, which are contained in the investors’ portfolios. Any investment information contained herein has been secured from sources that Yieldstreet believes are reliable, but we make no representations or warranties as to the accuracy of such information and accept no liability therefore.

Private placement investments are NOT bank deposits (and thus NOT insured by the FDIC or by any other federal governmental agency), are NOT guaranteed by Yieldstreet or any other party, and MAY lose value. Neither the Securities and Exchange Commission nor any federal or state securities commission or regulatory authority has recommended or approved any investment or the accuracy or completeness of any of the information or materials provided by or through the website. Investors must be able to afford the loss of their entire investment.

Investments in private placements are speculative and involve a high degree of risk and those investors who cannot afford to lose their entire investment should not invest. Additionally, investors may receive illiquid and/or restricted securities that may be subject to holding period requirements and/or liquidity concerns. Investments in private placements are highly illiquid and those investors who cannot hold an investment for the long term (at least 5-7 years) should not invest.

Alternative investments should only be part of your overall investment portfolio. Further, the alternative investment portion of your portfolio should include a balanced portfolio of different alternative investments.

Articles or information from third-party media outside of this domain may discuss Yieldstreet or relate to information contained herein, but Yieldstreet does not approve and is not responsible for such content. Hyperlinks to third-party sites, or reproduction of third-party articles, do not constitute an approval or endorsement by Yieldstreet of the linked or reproduced content.

Investing in securities (the "Securities") listed on Yieldstreet™ pose risks, including but not limited to credit risk, interest rate risk, and the risk of losing some or all of the money you invest. Before investing you should: (1) conduct your own investigation and analysis; (2) carefully consider the investment and all related charges, expenses, uncertainties and risks, including all uncertainties and risks described in offering materials; and (3) consult with your own investment, tax, financial and legal advisors. Such Securities are only suitable for accredited investors who understand and are willing and able to accept the high risks associated with private investments.

Investing in private placements requires long-term commitments, the ability to afford to lose the entire investment, and low liquidity needs. This website provides preliminary and general information about the Securities and is intended for initial reference purposes only. It does not summarize or compile all the applicable information. This website does not constitute an offer to sell or buy any securities. No offer or sale of any Securities will occur without the delivery of confidential offering materials and related documents. This information contained herein is qualified by and subject to more detailed information in the applicable offering materials. Yieldstreet™ is not registered as a broker-dealer. Yieldstreet™ does not make any representation or warranty to any prospective investor regarding the legality of an investment in any Yieldstreet Securities.

YieldStreet Inc. is the direct owner of Yieldstreet Management, LLC, which is an SEC-registered investment adviser that manages the Yieldstreet funds and provides investment advice to the Yieldstreet funds, and in certain cases, to retail investors. RealCadre LLC is also indirectly owned by Yieldstreet Inc. RealCadre LLC is a broker-dealer registered with the Securities and Exchange Commission (“SEC”) and a member of the Financial Industry Regulatory Authority (“FINRA”) and the Securities Investor Protection Corporation (“SIPC”). Information on all FINRA registered broker-dealers can be found on FINRA’s BrokerCheck. Despite its affiliation with Yieldstreet Management, LLC, RealCadre LLC has no role in the investment advisory services received by YieldStreet clients or the management or distribution of the Yieldstreet funds or other securities offered on our through Yieldstreet and its personnel. RealCadre LLC does not solicit, sell, recommend, or place interests in the Yieldstreet funds.

Yieldstreet is not a bank. Certain services are offered through Plaid, Orum.io and Footprint and none of such entities is affiliated with Yieldstreet. By using the services offered by any of these entities you acknowledge and accept their respective disclosures and agreements, as applicable.

Investment advisory services are only provided to clients of YieldStreet Management, LLC, an investment advisor registered with the Securities and Exchange Commission, pursuant to a written advisory agreement.

Our site uses a third party service to match browser cookies to your mailing address. We then use another company to send special offers through the mail on our behalf. Our company never receives or stores any of this information and our third parties do not provide or sell this information to any other company or service.

Read full disclosure