The Goal of MPT
Developed by Harry Markowitz in the 1950s, Modern Portfolio Theory demonstrates how an investor can construct a portfolio to maximize expected return for a given level of risk. The key insight of MPT is that the risk of an individual asset should not be viewed in isolation, but rather in terms of how it contributes to the overall risk of the portfolio.
The Efficient Frontier
A central concept in MPT is the Efficient Frontier. The Efficient Frontier is a graph that represents the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Any portfolio that lies below the Efficient Frontier is considered sub-optimal, because it does not provide enough return for the level of risk.
The Role of Correlation
MPT relies heavily on the statistical concept of correlation, which measures how two securities move in relation to each other. By combining assets that have a low or negative correlation, an investor can reduce the overall volatility of their portfolio without sacrificing returns. For example, if you combine two assets that are perfectly negatively correlated, you can create a portfolio with zero risk.
Criticisms of MPT
While highly influential, MPT is not without its critics. The theory relies on a number of assumptions that may not hold true in the real world, such as the assumption that investors are rational and that asset returns follow a normal distribution. The model is also highly sensitive to its inputs (expected returns, volatilities, and correlations), which are difficult to forecast with accuracy.
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