WHAT IS THE MODERN PORTFOLIO THEORY?
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Harry Markowitz introduced the Modern Portfolio Theory in a 1952
edition of the Journal of Finance. In 1990, he won a Nobel Prize for
his theory on portfolio selection.
Portfolio Theory (MPT) is based on the direct link between risk and reward
in investment performance.
When investment prices fluctuate, there is an opportunity to
benefit by buying when prices are low and selling when they are high. The
greater the difference between the low and high prices, and the more frequently
prices change, the greater the opportunity for gain. The frequency and amount of
price fluctuation of an investment is called volatility.
Volatility is also a measure of investment
The more volatile an investment is, the more risk there is for
reward. The Modern Portfolio Theory suggests that there is a relationship
between risk and reward and that investors are rewarded for taking investment
risk over time.
The goal of Modern Portfolio Theory is to create portfolios with
the lowest possible volatility for any given investment return, and the highest
return for any given level of risk. Markowitz showed investors that the
information needed to evaluate the risk/return ratio on any portfolio can be
determined by using three statistical equations: mean, standard deviation, and
The first step of Modern Portfolio Theory is to identify an
investor's risk tolerance.
tolerance is the degree to which an investor can risk his investments to
achieve a specific rate of return.
If an investor has a low tolerance for risks and wishes to invest
more conservatively, he or she is said to be risk-averse. A portfolio is
then designed to match the risk tolerance of the investor.
To fully understand Modern Portfolio Theory, you will need
to be able to define a few terms.