Modern Portfolio Theory: The Efficient Frontier and Portfolio Optimization

Investors want the best possible return for a given amount of risk. In other words, they want to maximize risk-adjusted returns. Portfolio design is about the creation of a collection of assets whose combined risk level may be lower than that for any individual component. This apparent magic was first formalized by Harry Markowitz in the 1950s. He shared a Nobel Prize for this work, and his original ideas have been extended by other academics. These ideas are known collectively as modern portfolio theory (MPT). In this chapter we will use a stylized example to make the core elements of MPT clear (Figure 10.1).

Figure 10.1 Risk and returns for asset classes ...

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