Modern Portfolio Theory

Investing is a trade off between risk and expected return. In general, assets with higher expected returns are riskier.

Modern Portfolio Theory describes the direct relationship between risk and return and how combining uncorrelated asset classes in a portfolio helps the investor achieve a higher risk-adjusted rate of return. An example of two uncorrelated asset classes are large cap US stocks and high quality US bonds (we believe mutual funds are the best way to represent different asset classes).

MPT was developed by Harry Markowitz and published under the title “Portfolio Selection” in the 1952 Journal of Finance. MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification – chief among them, a reduction in the riskiness of the portfolio.