Modern Portfolio Theory (MPT) is a framework used for constructing investment portfolios by optimizing the trade-off between expected returns and risk faced by an investor. It is based on the premise that the expected return of a portfolio should not only consider the returns of individual assets but also take into account the correlation between those returns.
The fundamental principle of MPT is diversification- the idea that an investor can reduce risk by holding a portfolio of investments that are not perfectly correlated. The goal of MPT is to find the optimal portfolio, which is the portfolio that offers the highest expected return for a given level of risk, or the lowest level of risk for a given expected return.
MPT involves several steps, including:
1. Asset allocation: This is the process of deciding how to allocate investment capital across different asset classes such as stocks, bonds, commodities, real estate, etc. The allocation is based on the investor’s risk tolerance, investment horizon, and expected returns for each asset class.
2. Risk assessment: This is the process of assessing the risk of individual assets and the portfolio as a whole. Risk is typically measured by the standard deviation of returns, which is a measure of the volatility of an asset’s returns over time.
3. Portfolio optimization: This is the process of constructing a portfolio that maximizes expected returns for a given level of risk or minimizes risk for a given level of expected returns. The optimal portfolio is usually found by solving the mean-variance optimization problem, which involves finding the portfolio with the highest expected return for a given level of risk, or the lowest level of risk for a given expected return.
4. Performance monitoring: Once the portfolio is constructed, it’s crucial to monitor its performance regularly and make adjustments if necessary to keep it aligned with the investor’s goals.
In summary, MPT provides a framework for building investment portfolios that optimize the trade-off between expected returns and risk. It’s based on the principle of diversification, which reduces risk by holding investments that are not perfectly correlated.