The Modern Portfolio Theory (MPT) is a financial theory that describes, in mathematical terms, concepts such as diversification and risk management. MPT offers the investor a toolset for building a diversified portfolio, whose return is maximized for a given level of risk. The risk is commonly measured with the standard deviation or volatility.
An output of the MPT is the efficient frontier curve shown on the right. It looks like an upside down Nike swoosh. All the dots (in cyan) below and to the right of the curve represent the risk and return of portfolios that are less than efficient for various reasons.. The dots that are on the curve represent portfolio performances that are considered efficient. There are three noteworthy points on the curve:
Point A is the maximum return of the portfolio
Point B is the minimum risk of the portfolio
Point C is typically the investor’s preferred choice, as it thought to be a good compromise between the level of risk and the expected return. This is also the point in which the portfolio has the maximum Sharpe ratio.
Along with the efficient frontier curve, RichKat will provide suggested allocations for an efficient portfolio, i.e., portfolio consisting of the stocks you already own but with a different allocation so the risk and return ratio is considered efficient. It’s up to you to choose how much risk you want to take. You may also want to look at different stocks and see how it affects your portfolio.
