What is the name of the theory that emphasizes diversification to optimize risk and return?

• A. Modern Portfolio Theory
• B. Efficient Market Hypothesis
• C. Capital Asset Pricing Model
• D. Behavioral Finance

Answer: (A)

Diversification to optimize risk and return is the idea at the heart of Modern Portfolio Theory. This approach, developed by Harry Markowitz, shows that by combining assets whose returns don’t move in perfect lockstep, you can lower overall portfolio risk without sacrificing expected return. The math is mean-variance optimization: you pick asset weights to maximize expected return for a given level of risk, or equivalently minimize risk for a given return. The set of best possible portfolios traces out the efficient frontier, guiding how much risk you’re willing to take.

The key intuition is that different assets offset one another’s moves. When one asset is down, another might be up, so the portfolio’s overall volatility can be smaller than the volatility of its components. This formal framework laid the foundation for asset allocation and why spreading investments across different assets helps manage risk.

The other options describe different ideas. The Efficient Market Hypothesis focuses on markets pricing in information, not on how to diversify; the Capital Asset Pricing Model ties expected return to market risk (beta) but doesn’t by itself prescribe diversification; Behavioral Finance looks at how human psychology and biases affect decisions rather than the optimal diversification trade-off.