Modern portfolio theory (MPT) is a sophisticated investment decision approach that allows an investor to classify, estimate and control both the kind and amount of expected return and risk. Its roots lie in Markowitz's innovative research in the early 1950s which shows that, by investing in a number of securities (portfolio), an investor can maximize the expected return and minimize the risk. Essential to portfolio theory is its quantification of the relationship between risk and return. The basic assumptions of this theory are that security returns are multivariate normally distributed and that investors are risk averse, thus, they must be compensated for assuming risk and they should attempt to diversify their portfolio rather than hold the single asset with the highest expected return.

These assumptions imply two features of investment decisions under uncertainty. First, the distribution of future returns of a portfolio are only described by the mean and variance of these returns. Second, investors prefer higher expected returns to lower expected returns for a given level of portfolio variance and prefer lower variance to higher variance of portfolio returns for a given level of expected returns.