Modern Portfolio Theory (MPT) is a financial framework for maximizing portfolio returns for a given risk level, introduced by Harry Markowitz in 1952. It emphasizes diversification and the efficient frontier, a tool for optimal asset allocation. The theory's quantitative analysis, strengths, weaknesses, and practical implementation are discussed, along with its contrast to Behavioral Finance and its ongoing evolution.
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MPT is a framework for assembling a portfolio of assets that maximizes expected return for a given level of risk
Definition of Diversification
Diversification is the practice of spreading investments across different assets to reduce risk
Role of Diversification in MPT
MPT emphasizes the benefits of diversification in reducing unsystematic risk
MPT suggests that the risk of a single investment should be evaluated in relation to its contribution to the overall portfolio's risk and return profile, considering the correlation between assets
The efficient frontier is a curve that represents the set of optimal portfolios offering the highest expected return for a defined level of risk or the lowest risk for a given level of expected return
Investors can use the efficient frontier to identify the most efficient portfolio that aligns with their risk tolerance by minimizing the combined risk of assets for a given level of expected return
The efficient frontier is a fundamental tool for investors to achieve optimal asset allocation by balancing risk and return
The expected return of a portfolio is calculated as the weighted average of the expected returns of the individual assets in the portfolio
The formula \( R_p = \sum_{i=1}^{n} w_iR_i \) represents the expected return of a portfolio, where \( w_i \) is the proportion of the total portfolio value invested in asset \( i \) and \( R_i \) is the expected return of asset \( i \)
The mathematical approach of MPT allows investors to systematically consider how the combination of different assets impacts the overall risk and return of a portfolio
MPT has been subject to criticism for its reliance on historical data and assumptions of market efficiency and rational investor behavior
Rationality of Investors
MPT assumes that investors are rational and seek to maximize utility while being averse to risk
Equal Expectations and Access to Information
MPT assumes that all investors have the same expectations and access to information
Frictionless Markets
MPT assumes that markets are frictionless, with no transaction costs or taxes, and no restrictions on borrowing or lending
While these assumptions simplify the modeling process, they may not align with real-world conditions, limiting the practical applicability of MPT
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The theory introduced by ______ posits that unsystematic risk can be mitigated in a portfolio that is ______.
Harry Markowitz
well-diversified
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Purpose of the efficient frontier
To identify portfolios with the highest expected return for a given risk or the lowest risk for a given expected return.
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Role of asset allocation in MPT
To construct a portfolio with minimized combined risk for a target level of expected return, optimizing investment performance.
