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The Modern Portfolio Theory focuses on the relationship between assets in a portfolio in addition to the individual risk that each asset carries. It exploits the fact that a negatively correlated asset offsets losses that are incurred on another asset.
The theory demonstrates that portfolio diversification can reduce investment risk. In fact, modern money managers routinely follow its precepts. Passive investing also incorporates MPT as investors choose index funds that are low cost and well-diversified.
The theory is based on Markowitzs hypothesis that it is possible for investors to design an optimal portfolio to maximize returns by taking on a quantifiable amount of risk. Essentially, investors can reduce risk through diversification using a quantitative method.
The modern portfolio theory (MPT) is a practical method for selecting investments in order to maximize their overall returns within an acceptable level of risk. This mathematical framework is used to build a portfolio of investments that maximize the amount of expected return for the collective given level of risk.
Harry Markowitz (born 1927) is a Nobel Prize-winning American economist best known for developing Modern Portfolio Theory (MPT), a groundbreaking investment strategy based on his realization that the performance of an individual stock is not as important as the performance and composition of an investors entire
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What is MPT? Markowitz created a formula that allows an investor to mathematically trade off risk tolerance and reward expectations, resulting in the ideal portfolio. MPT works under the assumption that investors are risk-averse, preferring a portfolio with less risk for a given level of return.
Portfolio theory as describes by Markowitz is most concerned with the effect of diversification on portfolio risk.
A key component of the MPT theory is diversification. Most investments are either high risk and high return or low risk and low return. Markowitz argued that investors could achieve their best results by choosing an optimal mix of the two based on an assessment of their individual tolerance to risk.