Modern Portfolio Theory – Basics

MPT is based on the behavior of the investor. The investor may make decision based on the expected return and the riskiness of returns. The higher the level of fluctuations, the higher is the risk. Therefore an investor may not prefer a share having higher level of fluctuations price.  He may prefer a share even with a lower return, if the risk is low. To reduce the risk, an investor may invest in different securities. Loss, if any, in one security will be offset by gain in another.  Portfolio means holding number of securities at a time by an investor. MPT is based upon its analysis on risk and return. When two varieties of securities have got equal risk, an investor may decide in favor of a security which is expected to yield higher return. If such two varieties of securities are expected to yield equal return, an investor may prefer a security having lesser risk. 

Now, to reduce risk, one may invest in more than one security, but one must also limit the diversification. This is because; again risk may be higher when the diversification is very high.  One may also think of holding all variety of securities. Such holdings will be called as market portfolio. The market portfolio is associated with the market risk. This market risk cannot be eliminated through diversification. Overall changes in the market price will have its own effect on a given security. The effect may change the degree of riskiness of a security. This is nothing but sensitivity of one security with reference to the changes in riskiness of other securities in the market.  This is known as the beta co-efficient of the security. That means, the return on a security depends on the risk measured by this beta.  The risk of investment in each security in terms of variations may be calculated in terms of percentage and then one security may be compared with the other. Such comparison may help the investor to decide how much he has to invest and in which security.

The expected return on each security may be arrived by means of weighted average. The comparison of estimation of risk and return of each security will place an investor in a better position to decide the purchase of each quantum of security, or not to make a purchase etc. The important point is that inspite of all such efforts regarding diversified investment one cannot reduce the risk to zero. The reality is that one has to accept the margin of market risk or non-diversifiable risk. The selected number of securities from the different industries is sufficient to analyze a market portfolio. The non-diversifiable risk or market risk may involve with risk associated with the fluctuations in the market index itself. The diversification will not eliminate the market risk. The non-diversifiable risk is also called as unavoidable risk and such risks cannot be diversified, because the entire market will be affected by one factor for e.g., common fiscal policy.

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