Unit 3: Modern Portfolio Theory

Modern Portfolio Theory (MPT), also known as mean-variance analysis, is a fundamental concept in finance that provides a framework for constructing and optimizing investment portfolios. Developed by Harry Markowitz in the 1950s, MPT revolutionized the field of portfolio management by introducing a systematic approach to balancing risk and return [Markowitz, 1952]. The fundamental principle of MPT is that investors can reduce the overall risk of the portfolio by combining assets that are not perfectly correlated, without sacrificing potential returns.

Portfolio Allocation Outline

In this unit, we will discuss the basics of portfolio allocation and how it can be used to build a diversified portfolio:

• Data-driven portfolio allocation is a portfolio optimization technique that uses statistical methods to identify the optimal combination of assets that maximizes return for a given level of risk. It builds on the classic Markowitz portfolio theory by incorporating machine learning and data analysis techniques to improve the accuracy of expected returns and covariance estimates.

• Model-driven portfolio allocation is a portfolio optimization technique that uses mathematical models to predict future returns and risks of different assets. It builds on the classic Markowitz portfolio theory by incorporating more sophisticated mathematical models such as stochastic calculus, econometric models, and factor models. This approach can lead to more accurate and efficient portfolio allocations by incorporating more detailed and nuanced market dynamics than traditional methods.

• Dynamically hedged portfolio allocation is an investment strategy that involves dynamically adjusting the composition of a portfolio in response to changing market conditions. The goal of the strategy is to minimize downside risk while maximizing upside potential. This is achieved by using a combination of hedging techniques, such as options or futures contracts, and active management of the portfolio’s asset allocation. The result is a more resilient and adaptive portfolio that can better navigate market fluctuations and deliver more consistent returns.