Modern Portfolio Theory

Explanation

MPT, developed by Harry Markowitz in 1952 (earning him the Nobel Prize), formalized the concept that diversification reduces risk. The efficient frontier shows the set of portfolios that offer the highest expected return for each level of risk. Key insight: a portfolio's risk depends not just on individual asset risks but on the correlations between assets. Adding a high-risk, low-correlation asset can actually reduce portfolio risk. MPT's assumptions (normal returns, rational investors, static correlations) are violated in practice, but the framework remains foundational.