Markowitz Portfolio Theory

Modern portfolio theory (MPT) is a theory of finance which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset.

 Portfolio theory is based on the assumption that the utility of an investor is a function of two factors. Mean (Expected Return) Variance (or its square root SD) Hence it is also referred to as the mean-variance portfolio or two parameter portfolio theory

Various assumptions of MPT

Investors base their decisions on expected return and risk, as measured by the mean and variance of the returns on various assets. All investors have the same time horizon All investors are in agreement as to the parameter necessary, and their values, in the investment decision making process, namely, the means, variances and correlation of returns on various investments (we say that the investors are homogenous)

 All investors are rational and risk-averse. All investors aim to maximize economic utility (in other words, to make as much money as possible, regardless of any other considerations) All investors have access to the same information at the same time. There are no taxes or transaction costs.- Real financial products are subject both to taxes and transaction costs (such as broker fees)