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Modern Portfolio Theory (MPT) 🧠📈

In 1952, a young economist named Harry Markowitz published a paper that changed finance forever. He introduced Modern Portfolio Theory (MPT), which proved that you can actually reduce the risk of a portfolio without necessarily reducing its return.

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1. The Core Idea: The Portfolio as a Whole

Before MPT, investors looked at each stock individually. They thought, "If I buy 10 good stocks, I have a good portfolio."

Markowitz argued that this was wrong. He showed that what matters is how the stocks move together (correlation).

Important

The Golden Rule of MPT: The risk of a portfolio is NOT just the sum of the risks of individual stocks. It depends on how the returns of those stocks interact with each other.

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2. Risk and Return in MPT

MPT uses two specific mathematical measures to build portfolios:

  1. Expected Return: The weighted average return of all assets in the portfolio.
  2. Standard Deviation (Risk): How much the portfolio's actual return might vary from the expected return.

Markowitz's goal was simple: To find the set of portfolios that give the maximum possible return for every level of risk.

3. The Efficient Frontier

The "Efficient Frontier" is a curve on a graph that represents the best possible portfolios.

  • Any portfolio on this curve is Efficient.
  • Any portfolio below this curve is Inefficient (because you could get a higher return for the same risk by moving up to the curve).
  • Portfolios above the curve are Impossible to achieve with the given assets.

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4. Why is MPT Revolutionary?

  1. Scientific Diversification: It moved diversification from "buying 10 stocks" to "buying stocks that don't move together."
  2. Risk Quantification: It turned risk from a "bad feeling" into a number (Standard Deviation).
  3. Optimal Selection: It gave investors a mathematical way to choose the best possible portfolio for their personal risk tolerance.

Summary

  • Created by Harry Markowitz in 1952.
  • Focuses on the interaction between assets, not individual asset quality.
  • The goal is to reach the Efficient Frontier.
  • Proved that diversifying across non-correlated assets is the best way to manage risk.

Quiz Time! 🎯

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