Overview

“Don’t put all your eggs in one basket.” MPT proves this mathematically. By combining assets that don’t move together (uncorrelated), you can reduce risk without reducing return.

Core Idea

Diversification: The only “free lunch” in finance. If you own one stock, you have high risk. If you own 500 stocks (S&P 500), the individual ups and downs cancel out, leaving only the market risk.

Formal Definition (if applicable)

Efficient Frontier: The set of optimal portfolios that offer the highest expected return for a defined level of risk. You want to be on the frontier.

Intuition

  • Stock A: Does well in summer (Ice cream).
  • Stock B: Does well in winter (Umbrellas).
  • Portfolio A+B: Does okay all year round. Less volatility, steady return.

Examples

  • 60/40 Portfolio: 60% Stocks (Growth), 40% Bonds (Safety).
  • Index Funds: Buying the whole market to get maximum diversification.
  • Rebalancing: Selling winners and buying losers to maintain your target allocation.

Common Misconceptions

  • “Diversification eliminates all risk.” (It eliminates idiosyncratic risk—company specific—but not systematic risk—market crashes.)
  • “More stocks is always better.” (After about 30 stocks, the benefit of diversification diminishes.)
  • Correlation: A measure of how two assets move together (-1 to +1). You want low or negative correlation.
  • Variance: A measure of volatility (risk).
  • Risk Tolerance: How much pain can you handle?

Applications

  • Retirement Planning: Asset allocation is the most important decision.
  • Endowments: Managing university funds.

Criticism / Limitations

Correlations tend to go to 1 during a crisis (everything crashes together). MPT assumes normal distributions (bell curves), but markets have “fat tails” (black swans).

Further Reading

  • Markowitz, Portfolio Selection
  • Bernstein, The Intelligent Asset Allocator