The principle theory behind the diversification concept is that investors should hold portfolios and focus on the relationship between the individual securities within the portfolio. In this case, the negative performance of a given asset/security within the portfolio is balanced out by the positive performance of other assets within the portfolio. Opportunity set: This is the set of available portfolios that an investor can choose based on their combinations of risk and return.ĭiversification: Diversification is the process of mixing different assets within a portfolio to ensure that unsystematic risk is smoothed out. Portfolio: A portfolio is a collection of assets such as stocks, property, bonds, currencies, etc.
Return: This is the reward an investor earns from investing/committing their capital to a given asset/security. Risk: In the context of MPT, risk can be defined as the variance or deviation of the investment return from the level expected. We define some of the basic terms which we will be using in the context of the Modern Portfolio Theory: Through the concepts presented in theory, investors can draw practical guides into constructing investment portfolios that maximize their expected return based on a given level of risk. Harry Markowitz conceptualized the Mean-Variance Portfolio Theory, also known as The Modern Portfolio Theory, in 1952. In a given market, an investor is presented with different assets/securities with different levels of return based on the underlying risk.Ī practical consideration rational investors face is how best to select the asset or combination of assets or security investments that present an optimal balance between risk and return on investment and maximizes their expected utility.
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