Portfolio Management - Portfolio Management Theories

Risk Aversion
Risk aversion is an investor's general desire to avoid participation in "risky" behavior or, in this case, risky investments. Investors typically wish to maximize their return with the least amount of risk possible. When faced with two investment opportunities with similar returns, good investor will always choose the investment with the least risk as there is no benefit to choosing a higher level of risk unless there is also an increased level of return.

Insurance is a great example of investors' risk aversion. Given the potential for a car accident, an investor would rather pay for insurance and minimize the risk of a huge outlay in the event of an accident.

Markowitz Portfolio Theory
Harry Markowitz developed the portfolio model. This model includes not only expected return, but also includes the level of risk for a particular return. Markowitz assumed the following about an individual's investment behavior:

  • Given the same level of expected return, an investor will choose the investment with the lowest amount of risk.
  • Investors measure risk in terms of an investment's variance or standard deviation.
  • For each investment, the investor can quantify the investment's expected return and the probability of those returns over a specified time horizon.
  • Investors seek to maximize their utility.
  • Investors make decision based on an investment's risk and return, therefore, an investor's utility curve is based on risk and return.


The Efficient Frontier
Markowitz' work on an individual's investment behavior is important not only when looking at individual investment, but also in the context of a portfolio. The risk of a portfolio takes into account each investment's risk and return as well as the investment's correlation with the other investments in the portfolio.

Look Out!
Risk of a portfolio is affected by the risk of each investment in the portfolio relative to its return, as well as each investment\'s correlation with the other investments in the portfolio.



A portfolio is considered efficient if it gives the investor a higher expected return with the same or lower level of risk as compared to another investment. The efficient frontieris simply a plot of those efficient portfolios, as illustrated below.

Figure 17.2: Efficient Frontier




While an efficient frontier illustrates each of the efficient portfolios relative to risk and return levels, each of the efficient portfolios may not be appropriate for every investor. Recall that when creating an investment policy, return and risk were the key objectives. An investor's risk profile is illustrated with indifference curves. The optimal portfolio, then, is the point on the efficient frontier that is tangential to the investor's highest indifference curve. See our article: A Guide to Portfolio Construction, for some essential steps when taking a systematic approach to constructing a portfolio.

Look Out!

The optimal portfolio for a risk-averse investor will not be as risky as the optimal portfolio of an investor who is willing to accept more risk.


Portfolio Calculations


Related Articles
  1. Professionals

    Portfolios

    Find out how portfolios are constructed and how to evaluate their performance.
  2. Options & Futures

    Financial Concepts: The Optimal Portfolio

    The optimal portfolio concept falls under the modern portfolio theory. The theory assumes (among other things) that investors fanatically try to minimize risk while striving for the highest ...
  3. Active Trading

    Modern Portfolio Theory: Why It's Still Hip

    See why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
  4. Bonds & Fixed Income

    Find The Highest Returns With The Sharpe Ratio

    Learn how to follow the efficient frontier to increase your chances of successful investing.
  5. Professionals

    The Workings Of Equity Portfolio Management

    Achieve analytical efficiency by applying your evaluation to a key set of stocks.
  6. Fundamental Analysis

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  7. Term

    Understanding Portfolio Investment

    Portfolio investment involves buying securities with the expectation of earning a return on them.
  8. Mutual Funds & ETFs

    Modern Portfolio Theory (MPT)

    Modern Portfolio Theory (MPT)
  9. Investing Basics

    Manage Investments And Modern Portfolio Theory

    Modern Portfolio Theory suggests a static allocation which could be detrimental in declining markets, making it necessary for continuous risk assessment. Downside risk protection may not be the ...
  10. Investing Basics

    Achieving Optimal Asset Allocation

    Minimizing risk while maximizing return is any investor's prime goal. The right mix of securities is the key to achieving your optimal asset allocation.
RELATED TERMS
  1. Homogeneous Expectations

    An assumption in Markowitz Portfolio Theory that all investors ...
  2. Efficient Frontier

    A set of optimal portfolios that offers the highest expected ...
  3. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment ...
  4. Modern Portfolio Theory - MPT

    A theory on how risk-averse investors can construct portfolios ...
  5. Portfolio Return

    The monetary return experienced by a holder of a portfolio. Portfolio ...
  6. Mean Return

    1. In securities analysis, it is the expected value, or mean, ...
RELATED FAQS
  1. What are the advantages of portfolio planning with the efficient frontier?

    Learn about modern portfolio theory and the efficient frontier. Understand the advantages of portfolio planning with the ... Read Answer >>
  2. How have portfolios from within the efficient frontier performed historically?

    Explore how the efficient frontier is used in selecting investment portfolios. Find out how risks and returns are used to ... Read Answer >>
  3. Why is risk return tradeoff important in designing a portfolio?

    Learn how the risk return tradeoff is used in the construction of portfolios, and how modern portfolio theory seeks to diversify ... Read Answer >>
  4. How is portfolio variance reduced in Modern Portfolio Theory?

    Learn about modern portfolio theory, specifically what it asserts about asset allocation and managing portfolio risk through ... Read Answer >>
  5. Is there a positive correlation between risk and return?

    Learn about the positive correlation between risk and the potential for return, and understand how risk is used to construct ... Read Answer >>
  6. How are negative correlations used in risk management?

    Learn about risk management and how negative correlations between assets are used to diversify and hedge risk associated ... Read Answer >>
Hot Definitions
  1. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  2. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  6. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
Trading Center