Insight: Modern Portfolio Theory

Modern Portfolio Theory was developed by William Sharpe and Harry Markowitz during the 1960's and established a risk/reward framework for investment decision making. It created a mathematical structure in which portfolios could be assembled whereby a collection of securities could carry less risk than any of the securities held independently. Simplified, Modern Portfolio Theory could determine the best portfolio mix for a given level of risk based on several assumptions. There are, of course, several limitations to this theory.

For example, one basic assumption of Modern Portfolio Theory is that if an investor is given a choice between two investment portfolios, each producing the same return, the investor will choose the portfolio that carries less risk. This assumption, of course, assumes that investors are rational. By extension, if investors are rational, then the prices reflected for individual securities in the market are efficient (accurate for the current situation).

Other assumptions include the notion that asset returns are normally distributed random variables (predictably unpredictable), correlations between assets are fixed and constant forever (the relationship between specific types of bonds and stocks do not change with market conditions), investors all have access to the same information at the same time, investors have an accurate perspective of possible returns, no taxes or transaction costs exist, investors do not influence prices, and investors can lend and borrow an unlimited amount of risk-free capital.

Modern Portfolio Theory is a good starting point. But it works best in conjunction with the other concepts listed.