Modern Portfolio Theory (MPT)
In this section of the website, we discuss Modern Portfolio Theory (MPT). Modern portfolio theory (MPT) was introduced by Harry Markowitz in 1952 in a paper “Portfolio Selection”.
It is is an investment theory that attempts to maximize a portfolio’s expected return for a given level of portfolio risk. Equivalently, the problem can also be specified to minimize risk for a given level of expected return. Modern portfolio theory does this by choosing the asset weights of a portfolio in an optimal way.
MPT makes the (fairly reasonable) assumption that investors are generally risk-averse. Being risk-averse means that an investor prefers a certain level of expected return over a higher level of uncertainty or risk. MPT argues that investors can construct portfolios that offer the highest expected return for a given level of risk by diversifying their investments across many assets and asset classes.
MPT is based on the concept of investment diversification. Investment diversification means that holding a diverse mix of assets, where the correlation between the assets is less than 1, can reduce the overall risk of a portfolio. In economic terms, this is the case because assets often have different return drivers, that is they tend to be affected by different economic and market factors.
As a consequence, the assets do not all perform poorly at the same time. By diversifying across assets, investors can offset the impact of poor performance by some assets with the good performance of other assets.
MPT has revolutionised the way investors think about risk and return. Mean-variance optimization has become a standard tool used by analysts and investors to determine the optimal allocation of assets in a portfolio. We should note, however, that MPT is not perfect and criticisms to the modern portfolio theory have been raised.
In this section of the website, we try to discuss and implement many of the concepts related to MPT. In particular, we try to add implementations in Microsoft Excel.