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Modern Portfolio Theory (MPT)

Modern Portfolio Theory founded by Harry Markowitz suggests the idea of creating an efficient portfolio to have the highest return with the lowest risk. It is based on certain assumptions some of which have been rejected by other financial experts. Nevertheless, the theory is considered an essential achievement on the financial world and due to the development of Sharpe Ratio investors can measure the risk-adjusted performance.

How Markowitz Put Forward the Idea of Portfolio Theory

The groundwork of MPT laid by Harry Markowitz is at the core of newly developed GeWorko Method. The theory of portfolio allocation under uncertainty appeared to be crucial one when it comes to investment diversification. It won him Nobel Memorial Prize and John von Neumann Theory Prize from the Operations Research Society of America. Currently, Mr. Markowitz is teaching at the University of California and is a practicing consultant in Investment Management, Business Management and Practice Development.

Modern Portfolio Theory (MPT) Definition

The concept of Portfolio Theory did not appear from a vacuum. It is based on the notion of statistical methods which roots go back to the 17th and 18th centuries. In that period a number of works on the theory of probability appeared which served as a basis for further development of portfolio theory. In 1657 the work on the calculus of probabilities, which was based on the thoughts of French mathematicians Blaise Pascal and Pierre de Fermat, was published by Christian Huygens.

The Harry Markowitz Model & MPT Assumptions

MPT stands for risk diversification in investing. The core of MPT is selecting a group of assets with lower collective risk than any of the single assets. Therefore, MPT allows to construct a maximum return portfolio for a given risk as well as to create portfolio with minimum risk for given return. Therefore, Modern Portfolio Theory is a strategic tool to diversify Your investments.

The Basics of Sharpe Ratio

The Sharpie Ratio is the “reward-to-variability ratio” written by Professor William F. Sharpe. It has proven to be one of the most effective and advanced risk/return estimation tools in finance that measures risk-adjusted performance. Through applying this ratio it is feasible to estimate if portfolio's returns are due to smart investment decisions or an outcome of excess risk. This becomes extremely useful for estimation of one’s strategy and fine-tuning of Your investment decisions.

Limitations of Modern Portfolio Theory (MPT)

Even though Modern Portfolio Theory is widely accepted and applied by investment institutions, it has been criticized as well. Particularly, the representatives of behavioral economics, behavioral finance challenge the MPT assumptions on investor rationality and return expectations. However, regardless the criticism MPT is a working investment diversification strategy that is implemented by risk managers, portfolio and investment institutions.