Modern Portfolio Theory (MPT)
Framework for constructing portfolios that maximize expected return for a given level of risk through diversification.
What it means
Modern Portfolio Theory (MPT), developed by Harry Markowitz in 1952, is a framework for constructing portfolios that maximize expected return for a given level of risk. The key insight is that portfolio risk depends not just on individual asset risk, but on how assets correlate with each other.
The math
The magic of MPT is in the covariance terms: when assets don't move together perfectly, combining them reduces overall portfolio risk below the weighted average of individual risks.
How to read it
- Core InsightDiversification can reduce risk without reducing expected return
- Optimal PortfoliosLie on the efficient frontier - maximum return for given risk
Worked example
Two stocks each with 20% volatility but 0 correlation combine into a portfolio with only 14.1% volatility (if equally weighted). The risk reduction is 'free' - expected return stays the same.
In context
MPT revolutionized investment management by formalizing diversification. It's the foundation of index investing, asset allocation strategies, and most institutional portfolio construction.
Common mistakes to avoid
- Assuming correlations and returns are perfectly predictable
- Ignoring that MPT assumes normal distributions (doesn't capture tail risk)
- Over-optimizing based on historical data (garbage in, garbage out)
Keep exploring
Efficient Frontier
The set of portfolios offering the highest expected return for each level of risk. Optimal portfolios lie on this curve.
Diversification
Spreading investments across different assets to reduce risk without sacrificing expected returns.
Correlation
Measures how two assets move together. Ranges from -1 (opposite) to +1 (identical). Key for diversification.
Sharpe Ratio
A measure of risk-adjusted return that compares excess return to volatility. Higher is better.
Capital Asset Pricing Model (CAPM)
A model relating expected return to systematic risk (beta). Foundation for understanding alpha and beta.
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