Modern Portfolio Theory (MPT), pioneered by Harry Markowitz, demonstrates that an asset's risk and return should not be assessed in isolation, but by how it contributes to an overall portfolio. By combining assets with low or negative correlation, an adviser maximizes expected return for a given level of risk on the Efficient Frontier.
Risk is divided into two categories: Systematic Risk (undiversifiable market-wide shocks, interest rate risk, inflation risk) and Unsystematic Risk (diversifiable firm-specific risk, credit risk, regulatory risk). Beta measures an asset's sensitivity to systematic market volatility relative to a benchmark (market beta = 1.0).
The Capital Asset Pricing Model (CAPM) calculates expected return based on systematic risk exposure. Jensen's Alpha measures the excess return generated by an investment manager above the CAPM prediction. Risk-adjusted ratios quantify efficiency: Sharpe divides excess return by total risk (standard deviation), whereas Treynor divides by market risk (beta).