What is the core idea of Modern Portfolio Theory (MPT)?

• A. Investors can construct portfolios to maximize expected return for a given level of risk by combining assets with imperfectly correlated returns
• B. Investors should hold only the single asset with the highest expected return
• C. Markets are always perfectly efficient
• D. Diversification cannot reduce risk

Answer: (A)

The idea being tested is that mixing assets with different return patterns can improve the trade-off between risk and return. By combining investments whose returns aren’t perfectly correlated, you can lower the overall portfolio volatility while maintaining or boosting expected return. This is the heart of mean-variance optimization in Modern Portfolio Theory, which leads to the efficient frontier—the set of portfolios that offer the highest expected return for each level of risk (or the lowest risk for each level of expected return).

This is the best description because it captures how diversification across imperfectly correlated assets reduces risk and enables a more favorable risk-return balance than any single asset could offer. The other options miss the diversification idea, either suggesting you should pick a single asset, assuming markets are always perfectly efficient, or claiming diversification cannot reduce risk.