Definition
Developed by Harry Markowitz in 1952 (Nobel Prize 1990), MPT mathematically demonstrates that diversification reduces portfolio risk without sacrificing return. By combining assets with imperfect correlations, investors can achieve portfolios on the "efficient frontier"—the set of optimal risk-return combinations. MPT shifted investing from individual stock picking to portfolio-level thinking.
functions Formula
Portfolio Variance = Σ Σ wᵢwⱼσᵢσⱼρᵢⱼ
lightbulb Example
Combining Stock A (15% return, 20% vol) with Stock B (10% return, 12% vol) at 50/50 with correlation 0.3: portfolio return = 12.5%, portfolio vol ≈ 13.3%. The vol is lower than either stock's vol alone due to diversification.
verified_user Key Points
- Foundation of portfolio construction theory
- Diversification reduces risk without sacrificing expected return
- Efficient frontier shows optimal portfolios
- Assumes normal distributions and rational investors