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Portfolio Construction·Modern Portfolio Theory
The Efficient Frontier
11 min read
Markowitz's diagram, 70 years on
Modern Portfolio Theory was published by Harry Markowitz in 1952 and won him the 1990 Nobel Prize. The core insight is that the volatility of a portfolio depends not just on the volatility of each asset, but on the correlations between them. By combining assets with low or negative correlations, a portfolio can achieve a higher expected return for the same volatility than any individual asset.
Portfolio variance (two-asset)
σ²_p = w_A² σ_A² + w_B² σ_B² + 2 w_A w_B ρ σ_A σ_B
Heads up
Estimation error eats MPT alive
The efficient frontier is exquisitely sensitive to expected-return inputs. A 1% error in expected returns can flip allocations by 50%. In practice, robust extensions (Black-Litterman, risk parity, shrinkage) are what desks actually run.