Modern Portfolio Theory

Modern portfolio theory is an investing strategy that minimizes market risk while maximizing returns. It is based on the premise that markets are efficient and utilizes diversification to spread investments across different assets. Modern Portfolio Theory is a statistical approach to investing developed by US economist Harry Markowitz that enables investors to select investment options that create the highest returns for an otherwise identical level of risk. That is, an optimal risk-adjusted return. Underlying MPT is the notion that investors will always seek a higher return for an otherwise equal level of risk and that a diversified portfolio will lower portfolio volatility regardless of the elements of individual asset volatility in the portfolio. Risk consists of systematic risk (risk that cannot be tamed through diversification as it affects the whole market) and unsystematic risk (the risk of individual securities that can be tamed through diversification). The extent of required diversification can be calculated by plotting the so-called Efficient Frontier (cf.).