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What is Modern Portfolio Theory?
Modern Portfolio Theory (MPT), developed by Nobel Laureate, Harry Markowitz, in the 1950s, is a framework for constructing optimal investment portfolios. MPT provides a mathematical approach to portfolio selection by considering the trade-off between risk and return. The key principles of Modern Portfolio Theory are as follows:
Diversification: MPT emphasizes the importance of diversifying investments across different asset classes, such as stocks, bonds, and other financial instruments. Diversification helps reduce the overall risk of the portfolio by spreading investments across various assets with different risk and return characteristics. By combining assets that are not perfectly correlated, MPT seeks to achieve a more efficient risk-return trade-off.
Efficient Frontier: MPT introduces the concept of the efficient frontier, which represents the set of portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of expected return. The efficient frontier is obtained by combining assets in different proportions, considering their expected returns, volatilities, and correlations.
Risk and Return Trade-off: MPT recognizes that investors are generally risk-averse and seek to maximize returns for a given level of risk or minimize risk for a given level of returns. MPT quantifies risk as the volatility or standard deviation of returns. It assumes that investors make decisions based on the expected returns and risk of the assets and aim to construct portfolios that maximize expected return while minimizing risk.
Capital Asset Pricing Model (CAPM): MPT incorporates the Capital Asset Pricing Model, which estimates the expected return of an asset based on its systematic risk (beta) and the expected market return. CAPM helps determine the optimal allocation of assets in the portfolio based on their expected returns and risk contributions.
Mean-Variance Optimization: MPT utilizes mean-variance optimization to find the optimal portfolio allocation. It aims to maximize the portfolio's expected return for a given level of risk or minimize the portfolio's risk for a given level of expected return. Mean-variance optimization involves considering the expected returns, volatilities, and correlations of the assets in the portfolio.
MPT has significantly influenced portfolio management practices and the field of finance. It provides a framework for constructing diversified portfolios based on quantitative analysis and the consideration of risk and return characteristics. However, it's important to note that MPT has certain assumptions and limitations, such as the reliance on historical data, the assumption of normal distribution of asset returns, and the neglect of non-financial factors. As a result, some variations and extensions of MPT have been developed to address these limitations and incorporate additional factors.
Modern Portfolio Theory is covered in more detail in module 2 of the CQF program.