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Modern portfolio theory
Modern portfolio theory is a method for portfolio management to reduce risk, which traces its origins to a 1952 paper by Nobel Prize winner Harry Markowitz. The theory states that, given a desired level of risk, an investor can optimise the expected returns of a portfolio through diversification. This is done by investing in less correlated assets and grouping correlated assets together with those that move in opposite directions to each another, so as to reduce risk for a given return. In a graph, the set of portfolios that maximise expected returns for a given standard deviation is represented by the ‘efficient frontier’.
Modern portfolio theory requires an expected return to be specified for each asset but this can be difficult. While expected returns can be estimated using historical data, the past is not necessarily indicative of the future.
An alternative is to replicate a market capitalisation portfolio and combine it with a portfolio made up of the same assets but weighted according to the investor’s views on expected returns for these assets and taking account of the investor’s confidence in those views. This approach was proposed by Fischer Black and Robert Litterman in 1992.
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