Modern portfolio theory (MPT).

In plain English

Modern portfolio theory holds that combining assets whose prices do not move together can lower total portfolio risk without giving up the same amount of expected return. The engine is correlation. Two holdings that rise and fall at different times partly cancel each other's swings, so the portfolio's volatility ends up lower than the weighted average of the parts. Under this framework an individual asset is judged by what it adds to the whole, which means a volatile holding can still improve a portfolio. The theory assumes investors care only about expected return and variance and that correlations hold up, and real markets sometimes break that last assumption exactly when it matters.

01Why it matters

It reframes the question from picking the best single investment to building a mix, which is why diversification is treated as a structural decision rather than a preference.

02The math, step by step

Two assets each swing about 20 percent a year. Held alone, either portfolio swings 20 percent. Split evenly with a correlation of zero, the combined swing falls to about 14 percent (20 divided by the square root of 2) while the expected return stays the average of the two.

Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.

03What this is NOT

04Receipts

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