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. 
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 riskaverse investor will not be as risky as the optimal portfolio of an investor who is willing to accept more risk. 

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. 
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. 
Professionals
The Workings Of Equity Portfolio Management
Achieve analytical efficiency by applying your evaluation to a key set of stocks. 
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. 
Investing Basics
Explaining The Efficient Frontier
Most investment choices involve a tradeoff between risk and reward. The "Efficient Frontier" is a modern portfolio theory tool that shows investors the best possible return they can expect from ... 
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 ... 
Fundamental Analysis
The History Of The Modern Portfolio
Learn how the writings of John Burr Williams and Harry Markowitz led to the creation of the investment portfolio. 
Term
Understanding Portfolio Investment
Portfolio investment involves buying securities with the expectation of earning a return on them. 
Options & Futures
Risk Tolerance Only Tells Half The Story
Just because you're willing to accept a risk, doesn't mean you always should. 
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.

Homogeneous Expectations
An assumption in Markowitz Portfolio Theory that all investors ... 
Efficient Frontier
A set of optimal portfolios that offers the highest expected ... 
Modern Portfolio Theory  MPT
A theory on how riskaverse investors can construct portfolios ... 
Portfolio Investment
A holding of an asset in a portfolio. A portfolio investment ... 
Markowitz Efficient Set
A set of portfolios with returns that are maximized for a given ... 
Portfolio Return
The monetary return experienced by a holder of a portfolio. Portfolio ...

What are the advantages of portfolio planning with the efficient frontier?
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How have portfolios from within the efficient frontier performed historically?
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Why is risk return tradeoff important in designing a portfolio?
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How is portfolio variance reduced in Modern Portfolio Theory?
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Is there a positive correlation between risk and return?
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How are negative correlations used in risk management?
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