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Finance Dictionary and Glossary of Investment Terms
Modern portfolio theory
Principles underlying the analysis and evaluation of rational portfolio choices based on risk-return trade-offs and efficient diversification.
Overall investment strategy that seeks to construct an optimal portfolio by considering the relationship between risk and return, especially as measured by alpha, beta, and R-squared. This theory recommends that the risk of a particular stock should not be looked at on a standalone basis, but rather in relation to how that particular stock's price varies in relation to the variation in price of the market portfolio. The theory goes on to state that given an investor's preferred level of risk, a particular portfolio can be constructed that maximizes expected return for that level of risk. also called modern investment theory.
A sophisticated investment approach developed by University of Chicago economist Harry Markowitz, who won a Nobel Prize in 1990, also called ""portfolio management theory"" or simply ""portfolio theory."" According to ""Wealth Enhancement & Preservation,"" ""Portfolio theory allows investors to estimate both the expected risks and returns, as measured statistically, for their investment portfolios. In his article ''Portfolio Selection'' (in the Journal of Finance, in March 1952), Markowitz described how to combine assets into efficiently diversified portfolios. He demonstrated that investors failed to account correctly for the variance among security returns. It was his position that a portfolio''s risk could be reduced and the expected rate of return could be improved if investments having dissimilar price movements were combined.For example, some companies'' stock tends to follow in step with overall economic trends. These are referred to as cyclical stocks. Other companies tend to do well when the economy does poorly, and these are known as counter-cyclicals. Holding securities that tend to move in concert with each other does not lower your risk. ''Diversification reduces risk only when assets are combined whose prices move inversely, or at different times, in relation to each other.'' ""In other words, Markowitz explained how to best assemble a diversified portfolio, and proved that such a portfolio would likely do well. Markowitz also proved that, all things being equal, the portfolio with the least amount of volatility would do better than one with a greater amount of volatility.