1.1 Introduction1.2 How To Read A Prospectus

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.

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

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.
2. Investing

How to Create a Low-Risk, High-Return Portfolio

Modern portfolio theory states diversification will create a lower-risk, higher-return portfolio.
3. Investing

Using Normal Distribution Formula To Optimize Your Portfolio

Normal or bell curve distribution can be used in portfolio theory to help portfolio managers maximize return and minimize risk.
4. 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.
5. Investing

5 Ways To Measure Mutual Fund Risk

These statistical measurements highlight how to mitigate risk and increase rewards.
6. Investing

Explaining The Efficient Frontier

Most investment choices involve a tradeoff between risk and reward. The "Efficient Frontier" is a modern portfolio theory tool that shows investors the best possible return they can expect from ...
7. Investing

How To Manage Portfolio Risk

Follow these tips to successfully manage portfolio risk.
8. 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.
9. Investing

Hot or Not: Single Stocks in Your Portfolio

It can be rewarding to invest in well-performing companies, but single stocks can present some downside for your portfolio, too. Here's why.