Modern portfolio theory (MPT) sets out how risk-conscious investors can assemble portfolios to maximize or optimize expected future returns taking into account a given level of market risk. The premise that taking risk is an inherent part of greater reward is paramount. An “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk is feasible to assemble.
MPT assumes that investors are risk-averse, preferring a less risky portfolio to a more risky one for a given level of return. This implies than an investor will take on more risk only if they are expecting more reward.
Every possible combination of assets that exists can be plotted on a graph, with the portfolio’s risk on the X-axis and the expected return on the Y-axis. This plot reveals the most desirable portfolios. For example, assume Portfolio A has an expected return of 6.5% and a standard deviation of 7%, and that Portfolio B has an expected return of 6.5% and a standard deviation of 9.0%. Portfolio A would be deemed more “efficient” because it has the same expected return but a lower risk. It is possible to draw an upward sloping hyperbola to connect all of the most efficient portfolios, and this is known as the efficient frontier. Investing in any portfolio not on this curve is not desirable.