Modern Portfolio Theory
The framework holding that assets should be judged by their contribution to a portfolio's risk and return, not in isolation.
How it is identified
Portfolio Return = Sum of Weighted Returns; Portfolio Variance = Sum over all pairs of (Weight i x Weight j x Covariance of i and j)
Unit
qualitative
In depth
Markowitz's central insight — that a volatile asset can reduce portfolio risk if it is uncorrelated with the rest — is the foundation of essentially all modern asset allocation, and it remains sound. Its assumptions are less sound: returns are not normally distributed, correlations are not stable, and expected returns cannot be estimated reliably. The theory also treats variance as risk, which conflates upside and downside. It is best used as a way of thinking about interactions between holdings rather than as a machine for producing portfolios.
Worked example
Adding a 20%-volatility asset to a 20%-volatility portfolio at a correlation of 0.3 gives 16.1% portfolio volatility. The added asset is exactly as volatile as what is held and reduces total risk by four percentage points.
Illustrative figures, chosen so the arithmetic is easy to follow. Not a live price and not a valuation of any company.
Educational reference only
This entry explains what “Modern Portfolio Theory” means. It is not investment advice and not a recommendation to buy or sell any security. Any numbers above are illustrative, not live prices, and nothing here predicts price direction or rates a stock. Consider your own circumstances and consult a SEBI-registered investment adviser before acting.