Modern portfolio theory

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Modern portfolio theory

Principals underlying the analysis and evaluation of rational portfolio choices based on risk return trade-offs and efficient diversification.

Modern Portfolio Theory

A theory of investing stating that every rational investor, at a given level of risk, will accept only the largest expected return. More specifically, modern portfolio theory attempts to account for risk and expected return mathematically to help the investor find a portfolio with the maximum return for the minimum about of risk. A Markowitz efficient portfolio represents just that: the most expected return at a given amount of risk (sometimes excluding zero risk). Harry Markowitz first began developing this theory in an article published in 1952 and received the Nobel prize for economics for his work in 1990. See also: Homogenous expectations assumption, Markowitz efficient set of portfolios.

modern portfolio theory

Modern portfolio theory.

In making investment decisions, adherents of modern portfolio theory focus on potential return in relation to potential risk.

The strategy is to evaluate and select individual securities as part of an overall portfolio rather than solely for their own strengths or weaknesses as an investment.

Asset allocation is a primary tactic according to theory practitioners. That's because it allows investors to create portfolios to get the strongest possible return without assuming a greater level of risk than they are comfortable with.

Another tenet of portfolio theory is that investors must be rewarded, in terms of realizing a greater return, for assuming greater risk. Otherwise, there would be little motivation to make investments that might result in a loss of principal.