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.

Modern 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 risk.

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 correlation.

The first step of Modern Portfolio Theory is to identify an investor's risk tolerance.

Risk 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.