What is 'Modern Portfolio Theory  MPT'
Modern portfolio theory (MPT) is a theory on how riskaverse 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. 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.
BREAKING DOWN 'Modern Portfolio Theory  MPT'
Modern portfolio theory argues that an investment's risk and return characteristics should not be viewed alone, but should be evaluated by how the investment affects the overall portfolio's risk and return.
MPT shows that an investor can construct a portfolio of multiple assets that will maximize returns for a given level of risk. Likewise, given a desired level of expected return, an investor can construct a portfolio with the lowest possible risk. Based on statistical measures such as variance and correlation, an individual investment's return is less important than how the investment behaves in the context of the entire portfolio.
Portfolio Risk and Expected Return
MPT makes the assumption that investors are riskaverse, meaning they prefer a less risky portfolio to a riskier one for a given level of return. This implies than an investor will take on more risk only if he or she is expecting more reward.
The expected return of the portfolio is calculated as a weighted sum of the individual assets' returns. If a portfolio contained four equallyweighted assets with expected returns of 4, 6, 10 and 14%, the portfolio's expected return would be:
(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%
The portfolio's risk is a complicated function of the variances of each asset and the correlations of each pair of assets. To calculate the risk of a fourasset portfolio, an investor needs each of the four assets' variances and six correlation values, since there are six possible twoasset combinations with four assets. Because of the asset correlations, the total portfolio risk, or standard deviation, is lower than what would be calculated by a weighted sum.
Efficient Frontier
Every possible combination of assets that exists can be plotted on a graph, with the portfolio's risk on the Xaxis and the expected return on the Yaxis. This plot reveals the most desirable portfolios. For example, assume Portfolio A has an expected return of 8.5% and a standard deviation of 8%, and that Portfolio B has an expected return of 8.5% and a standard deviation of 9.5%. Portfolio A would be deemed more "efficient" because it has the same expected return but a lower risk. It is possible to draw an upward sloping hyperbola to connect all of the most efficient portfolios, and this is known as the efficient frontier. Investing in any portfolio not on this curve is not desirable.
Harry Markowitz was awarded a Nobel prize for developing MPT.

Homogeneous Expectations
Homogenous expectations is an assumption in Portfolio Theory ... 
Inefficient Portfolio
An inefficient portfolio is one that delivers an expected return ... 
Markowitz Efficient Set
The Markowitz efficient set is a portfolio with returns that ... 
Efficient Frontier
Efficient frontier is a portfolio that offers the highest expected ... 
Expected Return
Expected return is the amount of profit or loss an investor would ... 
Portfolio Variance
Portfolio variance is the measurement of how the actual returns ...

Managing Wealth
Modern Portfolio Theory: Why It's Still Hip
Investors still follow an old set of principles, known as modern portfolio theory (MPT), that reduce risk and increase returns through diversification. 
Financial Advisor
Example of Applying Modern Portfolio Theory (MPS)
Modern Portfolio Theory: brush up on key mathematical framework used in investment portfolio construction. 
Managing Wealth
Manage Investments And Modern Portfolio Theory
Modern Portfolio Theory suggests a static allocation which could be detrimental in declining markets, making it necessary for continuous risk assessment. Downside risk protection may not be the ... 
Investing
How Investment Risk Is Quantified
FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk. 
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. 
Investing
How to Create a LowRisk, HighReturn Portfolio
Modern portfolio theory states diversification will create a lowerrisk, higherreturn portfolio. 
Investing
The Workings of Equity Portfolio Management
Portfolio management is a necessity, not an afterthought, in achieving analytical efficiency. 
Investing
6 Risks Threatening Your Portfolio Today
Factoring in these risks is crucial when building a portfolio. 
Financial Advisor
4 Reasons Why Market Correlation Matters
Learn about how correlation can be used to measure how broader markets move in relation to each other. See how correlation is used to manage risk.

How do investment advisors calculate how much diversification their portfolios need?
Learn how modern portfolio theory (MPT) can help determine a diversified mix of assets for inclusion in a portfolio that ... Read Answer >> 
How is correlation used in modern portfolio theory?
Discover how modern portfolio theory and the efficient frontier use correlation between investment assets to predict an optimal ... Read Answer >> 
Is there a positive correlation between risk and return?
Learn about the positive correlation between risk and the potential for return, and understand how risk is used to construct ... Read Answer >> 
How is risk aversion measured in Modern Portfolio Theory (MPT)?
Find out how risk aversion is measured in modern portfolio theory (MPT), how it is reflected in the market and how MPT treats ... Read Answer >> 
Is variance good or bad for stock investors?
Learn how high variance stocks are good for some investors and how diversified portfolios can reduce variance without compromising ... Read Answer >>