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Modern portfolio theory (MPT) is a concept from finance that describes ways of diversifying and allocating assets in a financial portfolio in order to maximize the portfolio’s expected return given the owner’s risk tolerance. 

American economist Harry Markowitz first introduced MPT in a 1952 paper published in the Journal of Finance. What this type of diversification does is eliminate idiosyncratic risk, which is the risk inherent in a particular investment due to the unique characteristics of that investment.

When using MPT, an investor bundles different types of investments together so that the portfolio assets are inversely correlated. Put simply, the securities counterbalance one another such that when some of the securities fall in value, other securities rise an equal amount. Thus, the overall portfolio stays even. But as markets rise overall, the portfolio “boat” of securities rises along with the market’s rising tide.

MPT uses precise financial mathematics to carefully construct the portfolio.  The steps involved include:

  1. Valuing the securities that might be included in the portfolio,
  2. Calculating the desired asset allocation (or mix of assets),
  3. Performing calculations to optimize the portfolio to get the maximum amount of return for the minimum amount of risk, and
  4. Using financial analysis to monitor the portfolio to see if it meets expectations, and then making changes to the individual securities or asset mix when market conditions warrant a change. 
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