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Modern portfolio theory (MPT) is a

Modern portfolio theory (MPT) is a

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Published by Monu Vadhera

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Published by: Monu Vadhera on Feb 02, 2011
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05/12/2014

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Modern portfolio theory (MPT) is a theory of investment 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. That this is possible can be seen intuitively because different types of assets often change in value in opposite ways. For example, when prices in the stock market fall, prices in the bond market often increase, and vice versa.

it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price. MPT seeks to reduce the total variance of the portfolio return. But diversification lowers risk even if assets' returns are not negatively correlated²indeed. ‡ By combining different assets whose returns are not perfectly positively correlated. each on their own merits. Rather. ‡ The fundamental concept behind MPT is that the assets in an investment portfolio cannot be selected individually.‡ A collection of both types of assets can therefore have lower overall risk than either individually. . ‡ MPT also assumes that investors are rational and markets are efficient. even if they are positively correlated.

MPT explains how to find the best possible diversification strategy . Under certain assumptions and for specific quantitative definitions of risk and return. MPT describes how to select a portfolio with the highest possible expected return. For a given amount of risk. assets with higher expected returns are riskier. ‡ In general. MPT explains how to select a portfolio with the lowest possible risk ‡ MPT is therefore a form of diversification. Or.‡ Investing is a tradeoff between risk and expected return. for a given expected return.

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