Introduction to Modern Portfolio Theory
The purpose of this article is to provide a brief explanation of Markowitz’s modern portfolio theory and how you can use it to more effectively allocate your investment portfolio.
Perhaps equally important to what will be covered is what is excluded: this is not a mathematical derivation of the model. For a thorough explanation of the math behind the model, see this article in Wikipedia. The objective of this article is to show how you can apply modern portfolio theory in real life to create an optimized portfolio.
Portfolio theory
the study of the way in which an individual investor may theoretically achieve the
Alternatively, the portfolio may achieve for the investor a minimum amount of risk
for a given level of expected return.Return on a security comprises
or loss from holding the security over a given time period.
The expected return on the collection of securities within the portfolio is the
weighted average of the expected returns on the individual INVESTMENTS that comprise the portfolio. The important thing, however,is that the risk attaching
to a portfolio is less than the weighted average risk of each individual investment.
Introduction
In its simplest form, portfolio theory is about finding the balance between maximizing your return and minimizing your risk. The objective is to select your investments in such as way as to diversify your risks while not reducing your expected return. It is actually simple to apply and effective. While it does not replace the role of an informed investor, it can provide a powerful tool to complement an actively managed portfolio.