Modern Portfolio Theory (MPT) is a concept in financial economics that provides a framework for constructing portfolios that can achieve the highest expected return for a given level of risk. It was first introduced by Nobel Prize-winning economist Harry Markowitz in 1952.
The central idea of MPT is that investors can optimize their portfolios by combining different assets with low levels of correlation, such that the overall portfolio risk is reduced while maintaining or increasing expected returns. This is achieved through a process of diversification, which helps to reduce the impact of individual security risks on the overall portfolio.
One of the key components of MPT is the efficient frontier, which is a graphical representation of the trade-off between expected return and risk. The efficient frontier represents the set of portfolios that provide the highest expected return for a given level of risk or the lowest level of risk for a given expected return.
An example of a portfolio optimized using MPT might consist of a mix of stocks, bonds, and real estate. Stocks generally have a high expected return but also a high level of risk, while bonds generally have a lower expected return but also a lower level of risk. Real estate can offer a return and risk profile that lies somewhere in between these two asset classes. By combining these different assets in a well-diversified portfolio, an investor can potentially achieve a higher expected return than if they invested in just one asset class, while also reducing their overall portfolio risk.
It is important to note that MPT is based on certain assumptions, such as efficient markets and rational investor behavior, which may not always hold true in reality. Despite these limitations, MPT remains a widely used and influential concept in investment management and continues to be an important tool for financial advisors and individual investors alike.
