What does modern portfolio theory is traditional finance say about how an investor should form an optimal stock portfolio?

The Modern Portfolio Theory (MPT) refers to an investment theory that allows investors to assemble an asset portfolio that maximizes expected return for a given level of risk. The theory assumes that investors are risk-averse; for a given level of expected return, investors will always prefer the less risky portfolio.

Why should investors hold the market portfolio?

Under the CAPM, all investors hold the market portfolio because it is the optimal risky portfolio. Because it produces the highest attainable return for any given risk level, all rational investors will seek to be on the straight line tangent to the efficient set at the steepest point, which is the market portfolio.

What are the assumptions of the modern portfolio theory?

Modern Portfolio Theory (MPT) makes four key assumptions: • A rational investor chooses greater value over less value. A rational investor chooses less risk over more risk. An investment goal may be supported by more than one optimal portfolio. The probability of success increases over time with diversification.

How portfolio theory assumes that investors make investment decisions?

Portfolio theory describes how investors who make their decisions based solely on expected return (the mean or average return) and volatility (standard deviation) should make rational choices. Each investor chooses a portfolio from the efficient frontier10 based on his or her tolerance for risk.

Can portfolio theory actually be applied by investors to improve their investment returns?

The modern portfolio theory (MPT) is a method that can be used by risk-averse investors to construct diversified portfolios that maximize their returns without unacceptable levels of risk. The modern portfolio theory can be useful to investors trying to construct efficient and diversified portfolios using ETFs.