Economic fundamentals, such as interest rates and the level of business activity, influence the average returns of many assets. Because there are common elements underlying the returns to many different assets, the risk associated with one asset's returns is generally related to the risk associated with other assets' returns. The importance of the portfolio perspective is that the risk of individual investments should be judged in the context of how much risk they add to a portfolio rather than on how risky they are on a stand-alone basis.
Modern portfolio theory (MPT), the analysis of rational portfolio choices based on the efficient use of risk, marked a watershed in investment management. Professional investment practice began to incorporate disciplines that recognized the importance of the portfolio perspective for the achievement of investment objectives. The quantitative emphasis of MPT also helped spread the knowledge and use of quantitative methods in portfolio management.
Three developments in the investment community created the demand for the portfolio perspective.
- Institutional investing emerged worldwide to play an increasingly dominant role in financial markets. Measuring and controlling the risk of these large pools of money became an imperative.
- The increasing availability and declining cost of computer processing made it possible to implement MPT portfolio concepts.
- The last related development was the professionalism of the investment management field.