Markowitz’s Modern Portfolio Theory (MPT) revolutionized investment by introducing the concept of efficient portfolio selection.

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His theory, developed in the 1950s, emphasizes diversification to achieve optimal risk-return trade-offs. According to MPT, an investor can create a portfolio that maximizes returns for a given level of risk or minimizes risk for a given level of returns by combining assets with varying correlations.

The Capital Asset Pricing Model (CAPM), developed by William Sharpe, builds on Markowitz’s work. CAPM introduces the risk-free rate, market risk premium, and beta to determine the expected return on an asset. The key idea is that investors should be compensated for the time value of money and the systematic risk (beta) associated with an asset. The formula for the expected return of an asset in CAPM is:

[E(R_i) = R_f + \beta_i \times (E(R_m) – R_f)]

Where:

(E(R_i)) is the expected return of the asset.
(R_f) is the risk-free rate.
(\beta_i) is the asset’s beta, measuring its sensitivity to market movements.
(E(R_m) – R_f) is the market risk premium.

CAPM provides a more precise way to estimate expected returns and helps investors evaluate whether an asset is priced appropriately based on its risk. Both Markowitz’s MPT and CAPM remain foundational in modern portfolio management, guiding investors in constructing diversified portfolios that balance risk and return in line with their financial goals.