Modern Portfolio Theory (MPT)

1. Definition

Modern Portfolio Theory (MPT) is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. * Pioneered by Harry Markowitz (Nobel Prize winner), it proved that risk is an inherent part of higher reward.

2. The Power of Diversification

The core concept is that owning different kinds of assets can lower volatility. * Correlation: The key metric. It ranges from -1 to +1. * If you combine assets with Negative Correlation (e.g., when Stocks go up, Bonds tend to go down), you can reduce the overall risk of the portfolio without necessarily sacrificing returns. * Free Lunch: In finance, diversification is often called the "only free lunch."

3. Efficient Frontier

• A graphical representation of optimal portfolios.
• The Curve: It plots expected return (Y-axis) against risk/volatility (X-axis).
• Portfolios that lie on the curve offer the best possible return for their risk level. Portfolios below the curve are sub-optimal.

4. Key Takeaway

• Don't look at an asset's risk in isolation. Look at how it contributes to the overall risk of the portfolio.
• Even a risky asset (like Bitcoin) can reduce the overall portfolio risk if it behaves differently from the other assets you own.