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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.

Modern Portfolio Theory

In 1763 an English mathematician Thomas Bayes published his work to determine probabilities based on observed frequencies. Later in 1812, “The Analytic Theory of Probabilities” by Pierre-Simon Laplace, revealed probability estimates that could be used to solve various problems. However, all those theories were not enough for investors to reach the expected goal. Although they were familiar with the concepts of risk and return, as well as the concept of diversification, they could not measure them. It was Harry Markowitz who for the first time scientifically examined the concepts of portfolio and diversification. He showed and explained why and how a diversified portfolio can cause a decrease in the portfolio risk. Before that, to get maximum profits, investors concentrated on individually selecting high yielding stocks. So, in case some particular industry offered good returns, an investor would pick all stocks of his portfolio from the same industry, thus, taking an unwise portfolio management decision. Although it was possible to intuitively understand the Portfolio Theory, only due to Markowitz it became feasible to mathematically prove it.

The theory suggests that the expected return for a given amount of portfolio risk is tried to be maximized and conversely, the risk on a given level of expected return is attempted to be minimized. Hence, it’s an attempt to optimize a portfolio of assets maximizing the returns and minimizing the risks of the portfolio.

This fundamental concept of MPT risk diversification lies on the hypothesis that assets included in an investment portfolio should not be chosen individually. This is done by carefully choosing different assets and paying attention to how the price of each asset changes relative to the price of every other asset, involved in the portfolio rather than choosing securities individually.

To put it in other words, the theory applies mathematical models to construct an ideal portfolio for an investor to gain maximum return. Each asset, according to the theory, has its own risks and a portfolio of different assets will be of lower risk than an individual asset portfolio. To put it simply, the theory is focused on the importance of diversifying to reduce risk. Its main outcome is that with the best diversification, the risk extent of a portfolio will be less than the average risk extents of the assets it contains. The real and main problem is then identifying the proportion of each stock or asset class presented in the portfolio as to increase the return and reduce the risk. A portfolio, containing this balanced mix, will perform greatly regardless of the conditions in stock market.