Modern Portfolio Theory

Abstract This chapter surveys modern portfolio theory, which is one of the most spectacular developments of finance in the last 50 years. It starts with the basic one-period setup under the assumption of normality with the successive contributions including the basic Markowitz mean-variance framework, the efficient frontier, and the Sharpe-Lintner capital asset pricing model. Utility and risk aversion are also discussed. The chapter then discusses the multiperiod extension and Merton's optimal asset allocation. The second part of the chapter shows how to extend the framework to allow for parameter uncertainty. In that process, the chapter also briefly reviews needed concepts such as the predictive density, shrinkage, and how the Bayesian framework allows the incorporation of prior views to improve on the precision of estimates necessary in the portfolio construction process.