U.S. economist Harry M. Markowitz introduced the modern portfolio theory (MPT) in a 1952 research paper.
The behavior of investors as it relates to capital markets forms the backbone of the modern portfolio theory. It includes mathematical instruments designed to help investors build an optimal portfolio. Asset allocation in an optimal portfolio is based on an investor’s profit expectations and risk preferences, as well as their liquidity.
The Markowitz Paradigm primarily aims to determine the profits and volatility of different types of investments based on historical data.
The theories introduced by Markowitz are built around the model investor who trades rationally and focuses on personal gain, without taking on unnecessary risk. Markowitz assumes that the investor is risk-averse and counts on a normal distribution of profits. Standard deviations serve as a measure for risk. The theory also assumes a perfect capital market.
The modern portfolio theory serves as the theoretical basis for the classical method of asset allocation. Multiple investment theories and models are built on this theory.
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Capital Asset Pricing Model (CAPM)
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