What is Modern Portfolio Theory?

How Does Modern Portfolio Theory Work?

Modern Portfolio Theory asserts that the risk associated with holding individual investments can be mitigated by combining assets (such as cash, stocks, bonds, derivatives, and alternative assets) into a diverse portfolio. These assets will be combined based upon how they react to market forces. Financial analysts will apply variance and correlation tests for each asset in the portfolio based upon historical performance to make these determinations. By identifying how the assets will react with each other, it is possible to minimize the risk associated with each individual holding. Further, the approach can maximize returns by achieving a mix of holdings along the efficient frontier – which entails the maximum potential return for a given level of risk. This makes it possible to evaluate the risk and potential return of individual assets based upon its effect on the entire portfolio – as each asset may perform uniquely based upon market conditions. The theory relies on a buy-and-hold approach, rather than active trading pursuant to technical analysis or market trends.