Modern Portfolio Theory

Topics: Investment, Modern portfolio theory, Harry Markowitz Pages: 3 (1071 words) Published: July 31, 2010
The investment terrain has seen some major changes in the last two decades.  Financial and technology companies came and went, stock market values soared, plummeted and rebounded, housing derivatives blew up, and other foundations were laid bare.  Even the core of investing theories related to portfolios has come under pressure.  Yet the belief in Modern Portfolio Theory has remained strong amongst the investors. Modern Portfolio Theory (MPT) is a theory that tells investors how to minimise risks associated with investment and at the same time, maximise return on the investments by proper resource allocation and diversifying their portfolios – it is based on the theory that risk can be lessened by diversifying into uncorrelated asset classes. However, unless the correlations of the various asset classes are predictable, the reduction of risk may be lost. Investors expect to be rewarded for the level of risk they are taking in a particular market. According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk and there are four basic steps involved in portfolio construction: Security Valuation, Asset Allocation, Portfolio Optimization and Performance measurement. This theory of portfolio selection was coined by Harry Markowitz in his paper ‘Portfolio Selection’ which was published in the Journal of Finance in March, 1952. Even before Markowitz in 1952, investors were familiar with the notion being able to reduce exposure to risk by diversifying their portfolios. The proverb ‘never put all your eggs in one basket’ underlies this idea. Through his paper, Markowitz was able to use a mathematical framework to study the effects of asset risk, return, correlation and diversification on probable portfolio returns and was awarded the John von Neumann Theory Prize and the Nobel Memorial Prize in Economic Sciences. GROUND BREAKING:

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