Modern portfolio theory

Modern Portfolio Theory (MPT) is a mathematical framework that optimizes a portfolio's expected return for a given level of risk. It emphasizes that an asset's risk and return should be evaluated in the context of its contribution to the overall risk and return of the portfolio. By combining assets with varying risk profiles, MPT aims to achieve a balance that maximizes returns while minimizing risk.

The variance of an asset's return is used as a measure of risk, and MPT relies on historical variance and covariance of returns as a proxy for forward-looking risk assessments. This approach allows investors to construct portfolios that are less risky than holding individual assets. Diversification, the core principle of MPT, reduces unsystematic risk by spreading investments across different asset classes and sectors.

Economist Harry Markowitz introduced MPT in a 1952 paper, earning him the Nobel Memorial Prize in Economic Sciences. His work formalized the concept of diversification and established a systematic approach to portfolio construction. MPT's insights have had a profound impact on investment strategies and financial planning.