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Introduction to Modern Portfolio Theory

How many theories are there?

There's a lot more. And we're just getting started.

What is the Modern Portfolio Theory Based On?

MPT is also largely based on the Efficient Market Hypothesis (EMH). The theory automatically assumes that investors prefer a less risky portfolio rather than one that is higher risk. It describes how investors can construct portfolios around the amount of risk they are willing to take and at the same time, maximize their return.

The EMH states that the average return of a portfolio is 8%. The expected value of the portfolio's return is calculated as a weighted sum of each individual asset and the returns that they have each generated.

For example, if a portfolio contained five assets that were each equally weighed with an expected return of 5%, 10%, 15% and 20%, the portfolio

S expected return would be 10% since if we convert the percentages to decimals, (0.05x0.2)+(0.1x0.2)+(0.15x0.2)+(0.2x0.2).

Risk And Standard Deviation

A portfolio’s risk, or standard deviation, involves a complicated process of each asset’s variance and correlation. The variance is a formula used to compare an asset’s performance against the other assets as well as the mean.

Asset correlation quantifies the relationship between two or more assets and their dependency as it measures the relationship. So to calculate the risk of the five asset portfolios above, we need each of the asset’ variance and correlation. Because of the correlation, the total risk is lower than what it would be if it was calculated by a weighted sum.

Are Financial Markets Efficient?

A large component of the MPT is that financial markets are efficient. Therefore, at any given time, prices fully reflect the information that is available on a stock such as its intrinsic value. Investors can then take that public information to calculate on how they should proceed with their investments. Because the information is not privately-held and is accessible to everyone, no one will have an advantage over the other.

However, this idea can be considered to be flawed since MPT is based on theory and not practice. While information is ideally distributed equally, that is not true. Individuals who work in the finance industry will have far more knowledge than someone who is working in the humanities sector. Additionally, markets are not always efficient. If anything, they are inefficient. If they were always efficient, scandals such as insider trading would rarely, and most likely never occur.

Are People Rational?

Another key component of the MPT is that people are rational, which if you've reading us, you would know is far from the truth. If people were rational, investment bubbles such as the large Dot-com bust of the 1990’s, and some may say cryptocurrency, would not occur.

What do you think? Before you read onto the next article, do you think that MPT holds true in todays standards? (Hint: keep in mind the basic principles and its limitations!)

Let us know in the comments below!

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