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Modern Portfolio Theory - Explained

What is Modern Portfolio Theory?

Written by Jason Gordon

Updated at October 6th, 2021

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Table of Contents

What is Modern Portfolio Theory?How Does Modern Portfolio Theory Work?

What is Modern Portfolio Theory?

Modern Portfolio Theory (MPT) is an investing model based upon the level of market risk and expected return. The model is applied to a group of investments making up an investor's complete portfolio. The objective is to hold a combination of diverse assets (diversification) that minimize risk and maximize potential return. The theory relies on the precept that investors are risk-averse and will only accept the greater risk if there is a possibility of greater return.
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How Does Modern Portfolio Theory Work?

Modern Portfolio Theory asserts that the risk associated with holding individual investments can be mitigated by combining assets (such as cash, stocks, bonds, derivatives, and alternative assets) into a diverse portfolio. These assets will be combined based upon how they react to market forces. Financial analysts will apply variance and correlation tests for each asset in the portfolio based upon historical performance to make these determinations. By identifying how the assets will react with each other, it is possible to minimize the risk associated with each individual holding. Further, the approach can maximize returns by achieving a mix of holdings along the efficient frontier - which entails the maximum potential return for a given level of risk. This makes it possible to evaluate the risk and potential return of individual assets based upon its effect on the entire portfolio - as each asset may perform uniquely based upon market conditions. The theory relies on a buy-and-hold approach, rather than active trading pursuant to technical analysis or market trends.

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