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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.
MPT - Modern Portfolio Theory - represents the mathematical formulation of risk diversification in investing, that aims at selecting a group of investment assets which have collectively lower risk than any single asset on its own. This becomes possible, since various asset types frequently change in value in opposite directions. Actually investing, being a tradeoff between risk and return, presupposes that risky assets have the highest expected returns.
Thus, MPT shows how to choose a portfolio with the maximum possible expected return for the given amount of risk. It also describes how to choose a portfolio with the minimum possible risk for the given expected return. Therefore, Modern Portfolio Theory is viewed as a form of diversification which explains the way of finding the best possible diversification strategy.
Harry Markowitz model (HM model), also known as Mean-Variance Model because it is based on the expected returns (mean) and the standard deviation (variance) of different portfolios, helps to make the most efficient selection by analyzing various portfolios of the given assets. It shows investors how to reduce their risk in case they have chosen assets not “moving” together.
Modern Portfolio Theory relies on the following assumptions and fundamentals that are the key concepts upon which it has been constructed:
Two essential decisions are necessary to be made to choose the best portfolio from a number of possible portfolios, each with its risk and return opportunities:
Being an important achievement in the financial sphere, the theory has found ground in other fields as well. In 1970s, it was widely applied in the area of regional sciences to derive the relationship between variability and economic growth. Similarly it has been used in the field of social psychology to form the self-concept. Currently, it is used by experts to model project portfolios of both financial and non-financial instruments.