Modern Portfolio Theory (MPT), developed by Harry Markowitz in 1952, mathematically formalises the intuition that diversification reduces risk without proportionally reducing return.

The efficient frontier is the set of portfolios that offer the maximum expected return for a given level of risk (standard deviation), or equivalently, the minimum risk for a given expected return.

Portfolio space: Plot every possible combination of assets on a risk/return chart. Most portfolios cluster inside a curved region. The upper-left boundary of this region is the efficient frontier.

Key insight: Any portfolio not on the efficient frontier is 'dominated' — there exists another portfolio with either: - The same return but lower risk, or - The same risk but higher return

Rational investors should hold only portfolios on the efficient frontier. The specific point chosen depends on the investor's risk tolerance.