12.9 : Modern Portfolio Theory

Modern Portfolio Theory (MPT), developed by economist Harry Markowitz in the 1950s, revolutionized investment strategies by optimizing a portfolio's risk and return. The theory emphasizes diversification, suggesting that investors can maximize returns for a given level of risk by carefully combining assets with different risk and return profiles.

MPT is based on the idea that individual assets should not be evaluated in isolation but as part of a broader portfolio. The key metric is the portfolio's overall risk, measured as the standard deviation of returns. Investors can reduce portfolio risk by including assets with low or negative correlations without sacrificing expected returns. This principle of diversification helps balance losses in one asset class with gains in another, enhancing stability.

The Efficient Frontier is a fundamental concept of MPT, representing portfolios that offer the highest expected return for a given level of risk. Investors choose points along this curve based on their risk tolerance. Another vital element is the Capital Market Line (CML), which incorporates risk-free assets, further refining portfolio optimization.

MPT influences strategies across mutual funds, retirement plans, and institutional portfolios despite critiques about its reliance on historical data and assumptions of market efficiency.