Modern Portfolio Theory
Modern portfolio theory (MPT) is a concept developed by Harry Markowitz that describes the relationship between risk and return. At its core, MPT is about diversification, or using a mix of different types of assets in an investment portfolio. The theory suggests that an investor can maximize returns for a given level of risk by efficiently diversifying the portfolio and choosing investments that have the highest expected returns for their particular level of risk.
The central premise of MPT is that the best portfolio investments are those that provide the highest risk-adjusted return. MPT considers both the expected return and the risk of each asset, as well as the correlation of returns between the various assets. This helps to diversify risk while still providing a lower-risk return. By diversifying a portfolio, MPT suggests that investors can reduce the amount of risk they take on while still earning a higher return than they would have otherwise.
The main tool used to measure risk-adjusted returns is the Sharpe Ratio, which looks at both the actual return of a portfolio and the volatility of its returns, taking into account the risk-free rate of return (generally considered to be the rate of return on a risk-free investment such as U.S. Treasury bills). The higher the Sharpe ratio, the better the risk-adjusted return of the portfolio. A portfolio with a higher Sharpe ratio is considered to be better diversified and will generally have higher returns for a given level of risk.
MPT has been the subject of much research and debate over the last few decades. Some academics and investors have argued that MPT does not capture all of the risks associated with investing in financial markets, and that it disregards the impact of behavioral biases on investment decisions. Others have suggested that MPT offers useful insights into diversification and asset allocation, but they advocate applying the theory with a practical approach that considers the specific needs of an individual investor.
In summary, modern portfolio theory is a framework used by investors to achieve a higher return for a given level of risk. By diversifying their portfolios and taking into account the expected return and risk of the various assets, investors can maximize their risk-adjusted return. The theory has come under criticism in recent years, but its principles are still widely applied in practice by many investors.
