Modern Portfolio Theory

Modern Portfolio Theory(MPT) introduced by Harry Markowitz is an investment tool widely used in the industry.
MPT uses expected returns and risk to determine the most efficient invgestment portfolios by changing the asset weights, to create a portfolio whose total weight is one.

MPT with different risk-return ratios results in different efficient frontiers for the same assets. MPT uses covariance between assets when calculating an efficient frontier and the associated optimal portfolio.

MPT theory also has some inefficiencies and faults. As it uses historical data in proposing a portfolio and also it cannot facftor the recent activities like news.

Constructing the Portfolio

An efficient portfolio is one that provides the greatest expected return for a given level of risk, or equivalently, the lowest risk for a given expected return.

To construct an efficient portfolio, the investor must be able to quantify risk and provide the necessary inputs. There are three key inputs that are needed:

• future expected return (or simply expected return)
• variance of asset returns
• correlation (or covariance) of asset returns

Evaluating Performance

To trade a profitable portfolio, one generally wants to buy low and sell high. To systematically follow through on this, we need a forecast of future returns, a risk model, a trading cost model, and a portfolio construction algorithm using all of the above.

Beta is a key metric used to identify an individual stock or portfolio’s level of volatility against the market standard. Those looking to minimize risk in their portfolio will want to pay close attention to their beta metric and keep it as close to the market benchmark as possible.

Beta Value	Description
1.0	The stock moves in line with the broader market
2.0	The stock moves twice as much as the broader market
0.0	The stock's moves don’t correlate with the broader market
-1.0	The stock moves in the opposite direction of the broader market