Portfolio Theory

### Section: Portfolio Theory Estimated study time: 45 minutes Content: Exam weight (2026 curriculum): Portfolio Management — 8–12% of the CFA Level I exam. Source: CFA Institute Level I Exam page, fetched 2026-06-29. At Level I, Portfolio Management introduces the theoretical framework (MPT, CAPM, efficient frontier) that is built upon in Level II (Portfolio Management 10–15%) and forms the entire structure of Level III (Asset Allocation 15–20% + Portfolio Construction 15–20% of common core). Modern Portfolio Theory (MPT), developed by Harry Markowitz in the 1950s, provides the mathematical framework for constructing portfolios that maximize expected return for a given level of risk, or equivalently, minimize risk for a given expected return. The key insight is that what matters for a portfolio is not the risk of each individual asset in isolation, but its contribution to overall portfolio risk — and this contribution depends on how assets co-move (their correlations). Adding an asset with low or negative correlation to an existing portfolio reduces portfolio variance even if the asset itself has high volatility. This is the formal mathematical foundation for diversification: the benefit of combining assets that don't move perfectly together. Portfolio expected return is simply the weighted average of individual asset expected returns: E(Rp) = Σ(wi × E(Ri)). Portfolio variance, however, is not simply the weighted average of individual variances — the covariances (correlations) between assets matter: Var(Rp) = Σi Σj (wi × wj × Cov(Ri, Rj)). For a two-asset portfolio: Var(Rp) = w1^2 × σ1^2 + w2^2 × σ2^2 + 2 × w1 × w2 × σ1 × σ2…