Harry Markowitz is generally credited with inventing Modern Portfolio Theory. The two seminal references are to his paper Portfolio Selection (Journal of Finance, March 1952) and Portfolio Selection: Efficient Diversification of Investments (New York: John Wiley & Sons, 1959). Portfolio Theory is taught in almost every introductory finance class.

Markowitz suggested that an appropriate measure of a portfolio's risk is the variance of its returns (gains/losses). To lower the risk of a particular portfolio, you try to add assets that are uncorrelated, or negatively correlated with your other holdings. The idea is that when some of your investments pay off, others will tank, but your total returns will be smoother.

Map variance along the x-axis and return along the y-axis of a graph, then plot the variance and returns of different portfolios as a scatter-plot diagram. Efficient portfolios are the dots that have nothing directly above them (higher return for the same risk) or directly to their left (same return for less risk). If you connect the dots, you get the efficient frontier, which should be concave if viewed from the origin.

MPT also suggests there is an optimal portfolio for any given investor based on their risk-reward preferences. Visually, you can represent an investor's preferences as indifference curves (the investor is indifferent between all points on the curve) which should curve from bottom-left (low risk, low reward) to top-right (high risk, high reward). The optimal portfolio is where one of the investor's indifference curves is tangent to the efficient frontier.

Markowitz's Portfolio Theory makes a number of assumptions (investors base all decisions on risk and return alone, investors estimate risk with variance of returns, investors represent each investment opportunity as a probability distribution of expect returns, etc.) but the most important one is that investors prefer steady returns (i.e. they are risk neutral or risk averse).

Most professional financial planners construct portfolios by identifying asset classes, which are presumed to have specific, stable risk and return characteristics. A number of investment banks also have chief investment officers who routinely publish model portfolios that reflect their views. These portfolios have certain percentages allocated to different asset classes.

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