Modern portfolio theory (MPT)

Modern Portfolio Theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics. MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. That this is possible can be seen intuitively because different types of assets often change in value in opposite ways. For example, as prices in the stock market tend to move independently from prices in the bond market, a collection of both types of assets can therefore have lower overall risk than either individually. But diversification lowers risk even if assets' returns are not negatively correlatedindeed, even if they are positively correlated. More technically, MPT models an asset's return as a normally distributed function (or more generally as an elliptically distributed random variable), defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of the assets' returns. By combining different assets whose returns are not perfectly positively correlated, MPT seeks to reduce the total variance of the portfolio return. MPT also assumes that investors are rational and markets are efficient. MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical modeling of finance. Since then, many theoretical and practical criticisms have been leveled against it. These include the fact that financial returns do not follow a Gaussian distribution or indeed any symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on external events (especially in crises). Further, there is growing evidence that investors are not rational and markets are not efficient.

Concept The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on their own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price. Investing is a tradeoff between risk and expected return. In general, assets with higher expected returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the highest-returning available security, of course, unless negative holdings of assets are possible.)[4] MPT is therefore a form of diversification. Under certain assumptions and for specific quantitative definitions of risk and return, MPT explains how to find the best possible diversification strategy. History Harry Markowitz introduced MPT in a 1952 article[5] and a 1959 book.[6] Markowitz classifies it simply as "Portfolio Theory," because "There's nothing modern about it." See also this[4] survey of the history. Mathematical model In some sense the mathematical derivation below is MPT, although the basic concepts behind the model have also been very influential.[4] This section develops the "classic" MPT model. There have been many extensions since. Risk and expected return MPT assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk. The exact trade-off will be the same for all investors, but different investors will evaluate the trade-off differently based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-expected return profile i.e., if for that level of risk an alternative portfolio exists which has better expected returns.

Note that the theory uses standard deviation of return as a proxy for risk, which is valid if asset returns are jointly normally distributed or otherwise elliptically distributed. There are problems with this, however; see criticism. Under the model:
y y

Portfolio return is the proportion-weighted combination of the constituent assets' returns. Portfolio volatility is a function of the correlations ij of the component assets, for all asset pairs

Investment Portfolio Management and Portfolio Theory Portfolio theory is an investment approach developed by University of Chicago economist Harry M. Markowitz , who won a Nobel Prize in economics in 1990. Portfolio theory allows investors to estimate both the expected risks and returns, as measured statistically, for their investment portfolios. Markowitz described how to combine assets into efficiently diversified portfolios. It was his position that a portfolio's risk could be reduced and the expected rate of return could be improved if investments having dissimilar price movements were combined. In other words, Markowitz explained how to best assemble a diversified portfolio and proved that such a portfolio would likely do well.
A. Passive Portfolio Strategy: A strategy that involves minimal expectational input, and instead relies on diversification to match the performance of some market index. A passive strategy assumes that the marketplace will reflect all available information in the price paid for securities. B. Active Portfolio Strategy: A strategy that uses available information and forecasting techniques to seek a better performance than a portfolio that is simply diversified broadly. Moreover, there are three more types of Portfolios: 1. The Patient Portfolio:

This type invests in well-known stocks. Most pay dividends and are candidates to buy and hold for long periods ... Perhaps forever! The vast majority of the stocks in this portfolio represent classic growth companies, those that can be expected to deliver higher earnings on a regular basis regardless of economic conditions. 2. The Aggressive Portfolio: This portfolio invests in "expensive stocks" (in terms of such measurements as price-earnings ratios) that offer big rewards but also carry big risks. This portfolio "collects" stocks of rapidly growing companies of all sizes, that over the next few years are expected to deliver rapid annual earnings growth. Because many of these stocks are on the less-established side, this portfolio is the likeliest to experience big turnovers over time, as winners and losers become apparent. 3. The Conservative Portfolio: They choose stocks with an eye on yield, as well as earnings growth and a steady dividend history