Modern Portfolio Theory talks about the measures to be taken to optimize the investors’ portfolios. The theory proposes how an intelligent investor should use diversification in order to optimize his or her portfolio returns. The theory also discusses how those assets that are risky should be priced in the portfolio. The basic concepts of the Modern Portfolio Theory are Markowitz diversification, capital asset pricing model, the efficient frontier, the Capital Market Line, the Securities Market Line and the alpha and beta coefficients.
It was Harry Markowitz who developed the basics and built much of the structure of Modern Portfolio Theory. The greatest contribution of the theory is believed to be the introduction and establishment of the risk-return framework while taking decision for investments. The theory provided the investors with a mathematical approach to portfolio management and asset selection.
Modern Portfolio Theory is also popularly known as MPT model. The MPT of economic theory considers the return of an asset as a random variable and considers the portfolio as the weighted combination of assets. Hence the return of a portfolio, according to Modern Portfolio Theory, is defined as the weighted combination of the returns of the assets. The random variable taking the portfolio’s return has an expected value and a variance also. According to this model, risk is defined as the standard deviation of the return of portfolio.
According to MPT model hypotheses, it is assumed that – when the investors are given the choice of two assets, they will prefer to have the less risky one. Hence it can be said that the investor will take an asset with higher risk only if he is assured of getting compensation through high returns. Thus it can be implicated that an intelligent investor will never invest in a portfolio if there is a second portfolio providing more favorable risk-return profile features. The investors will always go for portfolio that offers better expected returns.
According to Modern Portfolio Theory, a quadratic utility function describes the investor’s risk and reward preference. This theory assumes that only the volatility and expected return of the portfolios matter to the investors. It has been seen that the investors are indifferent about the skew and kurtosis of the returns. In this theory the volatility is considered as the proxy for risk and the return is the expectation on the future.
Last Updated on : 1st July 2013