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Modern Portfolio Theory
Modern Portfolio Theory (MPT) was created by economist Harry Markowitz in 1952 to mathematically measure an individual’s risk tolerance and reward expectations. The theory was that constant variance allowed for a maximised expected return and to gain a constant expected return variance should be minimised. An asset must be considered in regard to how they will move within the market and by taking these movements into account an investment portfolio can be constructed that decreased risk and had a constant expected return.

The levels of additional expected returns are calculated as the standard deviation of the return on investment (square root of the variance). Standard deviation illustrates the fluctuation of an asset’s returns over the period of time creating an accepted trading range to estimate possible returns on the asset. This tool enables individuals to determine their level of risk aversion to create a diversified portfolio.

MPT has been critiqued for using standard deviation as a form of measurement. Standard deviation is a relative form of measurement and investors using this index for their risk assessment must analyse an appropriate context in which the market sits to ensure a quantified understanding of what the standard deviation means. MPT automatically assumes that investors have an aversion towards risk however can be used by all types of investors to suit their needs individually. Furthermore, under MPT, two portfolios could be represented by the same level of variance hence would be considered equally desirable. The first portfolio may experience small losses frequently, and the second may experience a singular decline. This contrast between portfolios needs to be examined by investors prior to their purchasing of assets. By eliminating downside risk instead of volatility, Post-modern portfolio theory aims to build on MTP.