The
modern portfolio theory states that portfolios can be made in order to maximize the returns expected. This theory also acknowledges the inevitability of risks and the fact that these risks are necessary to gain higher rewards. The modern portfolio theory is also known as portfolio management theory and portfolio theory. In his work, Portfolio Selection, published in 1952, Harry Markowitz first time stated this theory.
The modern theory of portfolio states that there are four steps required for constructing a portfolio. They are as follows:
Valuation of security
Allocation of assets
Optimization of portfolio
Measurement of performance
For any investor, receiving optimum returns and minimizing risks are the two most important aspects involved in the investment. Making the perfect investment is an almost impossible task. Rather, it can be stated flatly that it is an impossible task. The theory that comes closest and is regarded widely as the best one is the MPT or Modern Portfolio Theory. This theory opines that an investor should invest in a variety of stocks and not concentrate on the risks and returns of a single stock. The diversification thus achieved from investing in a variety of stocks lowers the risk level.
Risk, as defined by the MPT, is the inherent possibility of each stock to yield low returns. This deviation from average or the mean is present in every stock. This risk can be conveniently reduced if investment is made in diverse individual stocks. A risky asset added to another risky asset reduces the risk considerably. There are two kinds of risks specified by the Modern Portfolio Theory. They are as follows:
- Systematic Risks – these risks cannot be offset through diversification. Wars, recessions and interest rates are examples of this type of risk
- Unsystematic Risks – these risks are specific in nature and they can be eliminated through diversification and increase in the number of stocks in the portfolio of the investor. This kind of risk is also known as specified risk.