Building a portfolio
Modern portfolio theory
Also called MPT or Mean-variance optimisation
The framework that treats risk as portfolio-level volatility and finds the best return for a given level of it.
How it works
Its central insight is that an asset should be judged by what it does to the whole portfolio, not on its own. A volatile asset that moves differently from everything else can reduce total risk.
The output is the efficient frontier: the set of portfolios offering the highest expected return for each level of volatility. Everything below it is, in the model, avoidable inefficiency.
Where it misleads people
The model needs expected returns, volatilities and correlations as inputs, and all three are estimated from the past. Small errors in expected returns produce wildly different optimal portfolios, which is why naive optimisers output absurd concentration.
Related terms
- Efficient frontierThe curve of portfolios that deliver the highest expected return available at each level of risk.
- CorrelationA measure from −1 to +1 of how closely two investments move together.
- VolatilityHow much an investment’s returns bounce around their average — the standard measure of risk.
- Sharpe ratioReturn above the risk-free rate, divided by volatility — how much return each unit of risk bought.
- DiversificationSpreading money across things that do not move together, so no single failure can decide your outcome.
Mentioned in
More in Building a portfolio
- Rebalancing
- Investment policy statement
- Rebalancing band
- Home bias
- Risk tolerance
- Glide path
- Safe withdrawal rate
- Fund overlap
All 20 Building a portfolio terms · The full glossary, 433 terms
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