Terminology for Modern Portfolio Theory

Proponents of the Modern Portfolio Theory use a set of specialized terms to refer to the balance of risk and return in investments.

Optimal portfolios

When a portfolio can meet its expected returns with the smallest possible risk, it is called an optimal portfolio. By adjusting the allocation of investments in a portfolio, you can create a number of different optimal portfolios with varying returns. All of these portfolios provide the lowest level of risk possible for each level of return. They also provide the highest returns for each risk level.

The efficient frontier

This entire group of possible optimal portfolios is known as the efficient frontier. For each risk level, the efficient frontier locates the portfolio with the highest returns. It also reveals the portfolio with the smallest amount of risk for each level of return. An efficient frontier is charted as a curve like this:

The investor then uses the efficient frontier to choose a portfolio that matches his or her risk tolerance.

Systematic risk is the risk that assets in your portfolio will be affected by changes in their markets. Systematic risk is the risk of holding your portfolio. Investments in your portfolio are grouped into asset classes. Asset classes are another way of saying "investment type," such as cash equivalents, stocks, bonds, real estate, etc.

How assets move

Asset classes behave differently from one another. When one asset class moves up in value, another may lose value or not change at all. The degree to which the movement of one asset class relates to the movement in another is known as asset correlation. For example, if each time asset "A" gained or lost 10 percent, asset "B" also gained or lost 10 percent respectively, we would say that "A" and "B" were perfectly correlated. Their correlation would be +1. On the other hand, if every time "A" gained 10 percent, "B" lost 10 percent, we would say they are perfectly negatively correlated. Their correlation would be -1. Asset classes can be correlated to each other between -1 and +1 with 0 representing "uncorrelated."

Familiarity with these terms is essential to understanding how Modern Portfolio Theory helps investors determine the efficiency of their portfolios.