Question

What is modern portfolio theory

Answer 1

Modern portfolio theory (MPT) is a theory which states on how risk-averse investors constructs portfolios to optimize or maximize expected return based on a given level of market risk. It emphasizes that there can be no return without risk. As per the theory, it's possible to construct an "efficient frontier" of optimal portfolios which offers the maximum possible expected return for a given level of risk. Modern portfolio theory states that an investment's risk and return characteristics should not be viewed alone, but should be evaluated by how the investment affects the overall portfolio's risk and return.

MPT shows that its possible for an investor to construct a portfolio of multiple assets that can maximize returns for a given level of risk. Similarly given a desired level of expected return, an investor can construct a portfolio with the lowest possible risk. Based on statistical measures like variance and mean a person can look into portfolio rather than individual return and risk.

MPT makes the assumption that investors are risk-averse, meaning they prefer a less risky portfolio to a riskier one for a given level of return. This means an investor will be ready to take more risk if he is given an oppurtunity to earn more return.

The expected return of the portfolio is calculated as a weighted sum of the individual assets' returns. If a portfolio contained two equally-weighted assets with expected returns of 5% and 18%, the portfolio's expected return would be:

(5% x 25%) + (18% x 25%) = 11.5%

The portfolio's risk is denoted by  function of the variances of each asset and the correlations of each pair of assets. To calculate the risk of a two-asset portfolio, an investor needs each of the two assets' variances and one correlation values, since there are one possible two-asset combinations with two assets. Because of the asset correlations, the total portfolio risk, or standard deviation, is lower than what would be calculated by a weighted sum.

Every possible combination of assets that exists can be plotted on a graph, with the portfolio's risk on the X-axis and the expected return on the Y-axis. This plot reveals the most desirable portfolios. Only those portfolios which exist on the frontier are desirable and not otherwise.