What is modern portfolio theory (MPT)?

Modern Portfolio Theory (MPT) is a foundational concept in investment that emphasizes the importance of diversification and efficient portfolio construction to maximize expected returns for a given level of risk. It posits that an investor can create a more effective portfolio by carefully selecting a mix of different asset classes, which can include stocks, bonds, and other securities.

The framework specifically addresses how investors can optimize their portfolios by balancing expected returns and risk. It uses statistical measures, including the mean and variance of asset returns, to determine the best combination of investments that achieves the highest expected return for a specified level of risk or the lowest risk for a given expected return. This concept also introduces the efficient frontier, which illustrates the optimal risk-return trade-offs available to investors.

In contrast, the other options focus on narrower or misleading investment strategies that do not encapsulate the broader principles of MPT. For example, suggesting all investments should be in bonds does not allow for risk diversification, while predicting market fluctuations is not a core aspect of MPT. Additionally, limiting investments to blue-chip stocks ignores the advantage of including various asset classes to minimize risk and improve overall portfolio performance.