What theory, introduced by Harry Markowitz, focuses on reducing risk through diversification?

• A. Capital asset pricing model
• B. Modern portfolio theory
• C. Efficient market hypothesis
• D. Behavioral finance theory

Answer: (B)

The theory that focuses on reducing risk through diversification is Modern Portfolio Theory, developed by Harry Markowitz. This theory revolutionized the way investors think about portfolio construction by introducing the concept that a diversified portfolio can yield a better risk-return profile than individual securities or non-diversified portfolios.

The fundamental idea behind Modern Portfolio Theory is that by combining different assets, an investor can minimize the overall risk of the investment portfolio while still aiming for optimal returns. This is because different assets often react differently to market conditions, so their performance may not be correlated. By carefully selecting a mix of assets, an investor can reduce the impact of any single asset's poor performance on the entire portfolio.

This theory led to the establishment of the efficient frontier, which represents the set of optimal portfolios that offer the highest expected return for a defined level of risk. Investors can then use this model to make informed decisions about which assets to include in their portfolios based on their risk tolerance and return expectations.

The other theories listed do not specifically focus on the principle of diversification to manage risk. The Capital Asset Pricing Model deals with the relationship between systematic risk and expected return, the Efficient Market Hypothesis suggests that asset prices reflect all available information, and Behavioral Finance Theory examines how psychological factors influence investors