What is Modern Portfolio Theory?

Modern Portfolio Theory (MPT) is an investment framework that seeks to maximize a portfolio's return for a given level of risk, or, alternatively, to minimize risk for an expected level of return. It was introduced by Harry Markowitz in 1952, for which he won the Nobel Prize in Economics.

The fundamental principle of MPT is that the assets in a portfolio should not be selected individually on their own merits, but by how they contribute to the overall risk and return of the portfolio.

Key Concepts

1. Diversification

MPT mathematically demonstrates that diversification is the key to reducing risk. By combining assets that do not move in perfect sync (i.e., are not perfectly correlated), the total risk of the portfolio can be less than the sum of the individual risks of each asset. It's the famous saying: "Don't put all your eggs in one basket."

2. The Efficient Frontier

For any set of assets, there is an "Efficient Frontier." This is a curve that represents the set of "optimal" portfolios that offer:

The maximum expected return for a defined level of risk.
The minimum risk (volatility) for a defined expected return.

Any portfolio that is not on the Efficient Frontier is suboptimal, because there is another portfolio that offers a better return for the same level of risk, or the same return with less risk.

Efficient Frontier Source: Wikimedia Commons

3. Correlation

Correlation measures how two assets move in relation to each other. It ranges from -1 to +1:

+1 (Perfect Positive Correlation): The assets move in the same direction.
0 (No Correlation): The movement of one asset has no relationship to the other.
-1 (Perfect Negative Correlation): The assets move in opposite directions.

For effective diversification, an investor should look for assets with low or, ideally, negative correlations.

How is it applied in this tool?