Modern Portfolio Theory - MPT

AAA

DEFINITION of 'Modern Portfolio Theory - MPT'

A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

Also called "portfolio theory" or "portfolio management theory."

INVESTOPEDIA EXPLAINS 'Modern Portfolio Theory - MPT'

According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance.

There are four basic steps involved in portfolio construction:
-Security valuation
-Asset allocation
-Portfolio optimization
-Performance measurement

RELATED TERMS
  1. Portfolio Variance

    The measurement of how the actual returns of a group of securities ...
  2. Permanent Portfolio

    A portfolio construction theory devised by free-market investment ...
  3. Efficient Frontier

    A set of optimal portfolios that offers the highest expected ...
  4. Mutual Fund Theorem

    An investing theory, postulated by Nobel laureate James Tobin, ...
  5. Covariance

    A measure of the degree to which returns on two risky assets ...
  6. Risk Measures

    Statistical measures that are historical predictors of investment ...
RELATED FAQS
  1. How is portfolio variance reduced in Modern Portfolio Theory?

    According to modern portfolio theory, or MPT, portfolio variance can be reduced by diversifying a portfolio through the inclusion ... Read Full Answer >>
  2. Why is risk return tradeoff important in designing a portfolio?

    The risk-return tradeoff determines how aggressive an investor wants to be with the assets included in the portfolio. An ... Read Full Answer >>
  3. How reliable is the mean variance analysis of an investment?

    Mean variance analysis of an individual investment or asset can provide a historical measure of volatility for the investment. ... Read Full Answer >>
  4. Can a mean variance analysis be done for any investment?

    A mean variance analysis is performed on a group of assets in a portfolio across a certain time horizon. This analysis can ... Read Full Answer >>
  5. How do investment advisors calculate how much diversification their portfolios need?

    One effective tool for investment advisers to determine the amount of diversification necessary for a portfolio is modern ... Read Full Answer >>
  6. What are some of the uses of the coefficient of variation (COV)?

    In statistics, the coefficient of variation (COV) is a simple measure of relative event dispersion. It is equal to the ratio ... Read Full Answer >>
  7. How do you interpret the magnitude of the covariance between two variables?

    Covariance indicates the relationship of two variables whenever one variable changes. If an increase in one variable results ... Read Full Answer >>
  8. How is covariance used in portfolio theory?

    Covariance is used in portfolio theory to determine what assets to include in the portfolio. Covariance is a statistical ... Read Full Answer >>
  9. Where did Modern Portfolio Theory (MPT) come from?

    Modern portfolio theory, or MPT, came from Harry Markowitz and was first introduced in a paper titled "Portfolio Selection" ... Read Full Answer >>
  10. Is there a positive correlation between risk and return?

    There is a positive correlation between risk and return with one important caveat. There is no guarantee that taking greater ... Read Full Answer >>
  11. How does covariance impact portfolio risk and return?

    Covariance provides diversification and reduces the overall volatility for a portfolio. Covariance is a statistical measure ... Read Full Answer >>
  12. How is correlation used in modern portfolio theory?

    Modern portfolio theory (MPT) emphasizes that investors can diversify away the risk of investment loss by reducing the correlation ... Read Full Answer >>
  13. Is alpha the best risk measure?

    There are many different types of risk associated with investing, and it is almost impossible for any single technical indicator ... Read Full Answer >>
Related Articles
  1. Investing Basics

    Achieving Optimal Asset Allocation

    Minimizing risk while maximizing return is any investor's prime goal. The right mix of securities is the key to achieving your optimal asset allocation.
  2. Options & Futures

    How Risk Free Is The Risk-Free Rate Of Return?

    This rate is rarely questioned - unless the economy falls into disarray.
  3. Mutual Funds & ETFs

    Protect Your Foreign Investments From Currency Risk

    Hedging against currency risk can add a level of safety to your offshore investments.
  4. Professionals

    The Workings Of Equity Portfolio Management

    Achieve analytical efficiency by applying your evaluation to a key set of stocks.
  5. Mutual Funds & ETFs

    How To Pump Up Your Portfolio With ETFs

    These funds trade like stocks, provide diversification, reduce risk and increase returns.
  6. Mutual Funds & ETFs

    Strategies For Determining The Market's True Worth

    Learn the strengths and weaknesses of passive and active management when trying to uncover the overall market's worth.
  7. Forex Education

    Improve Your Investing With Excel

    Excel is a useful tool to assist with investment organization and evaluation. Find out how to use it.
  8. Insurance

    The Dangers Of Over-Diversifying Your Portfolio

    If you diversify too much, you might not lose much, but you won't gain much either.
  9. Active Trading

    Modern Portfolio Theory: Why It's Still Hip

    See why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
  10. Mutual Funds & ETFs

    Permanent Portfolio Locks In Long-Term Profits

    Harry Browne believes his "permanent portfolio" theory is the ideal long-term investing strategy.

You May Also Like

Hot Definitions
  1. Treasury Yield

    The return on investment, expressed as a percentage, on the debt obligations of the U.S. government. Treasuries are considered ...
  2. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
  3. European Central Bank - ECB

    The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed ...
  4. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  5. Current Account Deficit

    A measurement of a country’s trade in which the value of goods and services it imports exceeds the value of goods and services ...
  6. International Monetary Fund - IMF

    An international organization created for the purpose of: 1. Promoting global monetary and exchange stability. 2. Facilitating ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!