Understanding Modern Portfolio Theory

Modern Portfolio Theory (MPT) is a framework for creating diversified investment portfolios that aim to maximize returns for a given level of risk. It relies on the measurement of risk through volatility and standard deviation, requiring expected returns, volatilities, and correlations of asset classes to construct an optimal portfolio. While MPT serves as a valuable model for diversification, practical application reveals that investors often prefer portfolios that align with their preferences over pure optimization, resulting in constraints on certain assets. This human element introduces challenges as investors tend to favor familiar and comfortable investment choices rather than strictly adhering to MPT's recommendations.