Assumptions

MPT assumes that investors will act rationally, that they will aim to maximize returns while limiting risk. It also assumes they are receiving all information pertaining to their investments in a timely way. The theory claims that trying to beat the market through fundamentals and individual stock selection is futile.

Risk vs. Return

MPT compiles data on all asset classes and securities, such as stocks, bonds, currencies and real estate. It then calculates historical average returns. Risk is defined as deviation away from the mean historical returns during a particular time period. For example, U.S. stocks may average 11 percent returns over time. However, they may see a 33 percent gain one year and an 11 percent loss another year to arrive at that average.

Optimal Portfolio

According to MPT, the optimal portfolio takes into account probabilities, average returns and differences in competing asset classes. Generally, it claims that the greater the risk, the greater the potential returns.

Controversy

References

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