What is the basic idea behind modern portfolio theory (MPT)?

What is the basic idea behind modern portfolio theory (MPT)?

• A. To maximize return without considering risk.
• B. To construct a portfolio that maximizes expected return for a given level of risk through diversification.
• C. To select a single asset with the highest past return.
• D. To focus solely on risk reduction, ignoring returns.

Answer: (B)

Modern portfolio theory centers on balancing risk and return through diversification. It shows that by mixing assets whose price movements aren’t perfectly correlated, you can lower the overall portfolio risk while preserving or even increasing the expected return. The goal is to identify a portfolio that, for a given level of risk, delivers the highest possible expected return. This is the essence of maximizing return for a chosen amount of risk through diversification. The other approaches miss this trade-off: chasing the asset with the highest past return ignores how risk interacts with return across a portfolio, and focusing only on reducing risk or on a single asset doesn’t capture the benefits of combining different investments.

Modern portfolio theory centers on balancing risk and return through diversification. It shows that by mixing assets whose price movements aren’t perfectly correlated, you can lower the overall portfolio risk while preserving or even increasing the expected return. The goal is to identify a portfolio that, for a given level of risk, delivers the highest possible expected return. This is the essence of maximizing return for a chosen amount of risk through diversification. The other approaches miss this trade-off: chasing the asset with the highest past return ignores how risk interacts with return across a portfolio, and focusing only on reducing risk or on a single asset doesn’t capture the benefits of combining different investments.