## Modern Portfolio Theory (MPT)
Modern Portfolio Theory (MPT), developed by Harry Markowitz in the
1950s, revolutionized the way investors think about portfolio construction.
It's a powerful framework that helps investors build portfolios that
maximize expected returns for a given level of risk. Here's a detailed
breakdown:
**1. Core Principles:**
* **Risk and Return are Inseparable:** MPT acknowledges that higher
returns typically come with higher risk. It doesn't aim to eliminate risk
entirely, but rather to manage it effectively.
* **Diversification is Key:** MPT emphasizes that diversifying across
different asset classes (stocks, bonds, real estate, etc.) reduces overall
portfolio risk without sacrificing returns.
* **Correlation Matters:** The relationship between different assets (how
they move together) is crucial. Assets with low or negative correlation can
further reduce portfolio risk.
* **Efficient Frontier:** MPT identifies the set of portfolios that offer the
highest expected return for each level of risk. This set of portfolios forms
the "efficient frontier."
**2. Key Concepts:**
* **Expected Return:** The average return an investor anticipates from an
asset or portfolio over a specific period.
* **Risk (Standard Deviation):** A measure of how much an asset's or
portfolio's returns are likely to deviate from the expected return. Higher
standard deviation indicates higher risk.
* **Correlation:** The statistical relationship between the movements of
two assets. A correlation of 1 means they move perfectly together, -1
means they move perfectly opposite, and 0 means no relationship.
* **Covariance:** A measure of how two assets move together, taking
into account their individual volatilities.
