Modern Portfolio Theory (MPT) is the focus of this chapter. While previous chapters discussed how firms approach investing (using either the castle-in-the-air or firm-foundation theories), MPT is the approach employed by academics.
MPT asserts that the only way to achieve higher returns than the market is by taking higher risks. Furthermore, risk is defined as volatility. In other words, if a security's price changes by a larger percentage than the market (even if that change is positive), it is considered to be a higher risk than the market. Though Malkiel acknowledges that it is downside risk that is important (not upside), he shows that for indexes such as the S&P 500, the distribution of volatility is normal (meaning upside volatility is similar to downside volatility).
If you accept this definition of risk which lies as the basis for MPT, then there are some important implications. By diversifying, investors can reduce their risk for a given level of return. This concept is illustrated by Malkiel by way of example. If there are two businesses in town, an umbrella manufacturer and a resort owner, both with equal expected returns and equal volatility of those returns, an investment in either one of them could result in a loss (due to the volatility of returns). But because the umbrella manufacturer will do well when the resort owner does poorly, and vice versa, by owning both firms, the investor can achieve the same expected (or average) returns but without the volatility.
This concept is then extended to broader markets. An investor owning both US and Japanese stocks can achieve similar returns but with far less volatility than another investor who owns only one country's stocks. The concept can also be extended to other asset classes which don't have perfect correlation with the investor's portfolio (e.g. real estate). A criticism of this concept, however, is that when volatility rises (e.g. times of fear), correlations between asset classes tends to rise, and so the benefits of diversification are lost at the time in which they are needed most.
Later in the book, Malkiel will use MPT to create ideal asset allocations for investors of different age groups.