Modern Portfolio Theory (MPT), a hypothesis put forth by Harry Markowitz in his paper "Portfolio Selection," (published in 1952 by the Journal of Finance) is an investment theory based on the idea that 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. It is one of the most important and influential economic theories dealing with finance and investment.

Also called "portfolio theory" or "portfolio management theory," MPT suggests that it is possible to construct an "efficient frontier" of optimal portfolios, offering the maximum possible expected return for a given level of risk. It suggests that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification, particularly a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.

Related Readings:

Consider that, for most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls "risk."

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn't rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio.

In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's nest egg.

On the more technical side, there are five statistical risk measurements used in modern portfolio theory (MPT); alpha, beta, standard deviation, R-squared and the Sharpe ratio. All of these indicators are intended to help investors determine a potential investment's risk-reward profile.

SEE: 5 Ways To Measure Mutual Fund Risk




Total Portfolio Return, Mutual Fund Theorem and Alpha

Related Articles
  1. Investing

    Understanding Modern Portfolio Theory

    Modern portfolio theory describes ways of diversifying assets in a portfolio in order to maximize the expected return given the owner’s risk tolerance.
  2. Investing

    How to Create a Risk Parity Portfolio

    Learn about how risk parity uses leverage to create equal exposure to risk among different asset classes in portfolio construction.
  3. Investing

    Modern Portfolio Theory vs. Behavioral Finance

    Modern portfolio theory and behavioral finance represent differing schools of thought that attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and positions ...
  4. Investing

    The Dangers Of Over-Diversifying Your Portfolio

    If you over-diversify your portfolio, you might not lose much, but you won't gain much either.
  5. Investing

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  6. Investing

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
  7. Investing

    Find The Highest Returns With The Sharpe Ratio

    Learn how to follow the efficient frontier to increase your chances of successful investing.
  8. Financial Advisor

    How To Pump Up Your Portfolio With ETFs

    These funds trade like stocks, provide diversification, reduce risk and increase returns.
  9. Investing

    Understanding Volatility Measurements

    How do you choose a fund with an optimal risk-reward combination? We teach you about standard deviation, beta and more!
Frequently Asked Questions
  1. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  2. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  3. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
  4. What is the 1003 mortgage application form?

    Learn about the 1003 mortgage application form, what information it requires and why this form is the industry standard for ...
Trading Center