Modern Portfolio Theory

Investing requires a trade-off. You have to give up safety and take on risk to achieve better returns. Modern Portfolio Theory tries to make the most of the trade-off, illustrating how to generate as much return as possible for the least amount of risk.

Risk and Return

With any reward--such as a great-performing stock or fund--there's always some element of risk. And the greater the potential reward, the greater the potential risk.

It's hard to imagine a time when the risk/reward relationship was considered revolutionary. But, prior to Harry Markowitz's 1952 dissertation, Portfolio Selection, investment theory didn't discuss the risks of investing. Instead, it was flush with ideas for maximizing return.

Markowitz believed, and mathematically proved, that there is a direct relationship between an investment's risk and its reward. He saw risk as an equal partner with expected gain. As such, he argued that investors need to manage the tension between risk and return in the investment process.

Markowitz also argued that investors should be measuring, monitoring and controlling risk at the portfolio level – not at the individual-security level. As a result, individual securities should be chosen based not only on their own merit, but also on how they affect the portfolio as a whole.

Read Next: Diversification and an 'Efficient' Portfolio

Keep in mind that while diversification may help spread risk it does not assure a profit or protect against loss in a down market.