Modern Portfolio Theory

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Modern Portfolio Theory (MPT), developed by economist Harry Markowitz, is an investment framework that explains how investors can construct portfolios to balance expected return and risk through diversification. Rather than evaluating investments individually, MPT considers how different assets interact with one another, particularly their correlations and volatility. By combining assets that do not move exactly together, an investor may be able to reduce overall portfolio risk without necessarily sacrificing expected return. The central concept is the Efficient Frontier, which represents portfolios offering the highest expected return for a given level of risk. MPT therefore provides a systematic approach to asset allocation, diversification, portfolio construction, and risk management.

The Efficient Frontier is a key concept of Modern Portfolio Theory that identifies the portfolios offering the highest expected return for a given level of risk, or alternatively, the lowest risk for a given expected return. It is created by analyzing different combinations of investments and measuring their expected returns, volatility, and correlations with one another. Portfolios that fall below the Efficient Frontier are considered inefficient because another portfolio could potentially provide a higher return at the same level of risk or lower risk at the same expected return. The goal of portfolio construction is therefore to select a portfolio along the Efficient Frontier that best matches an investor’s desired balance between return and risk.