2154 words - 9 pages

On a general level, investment managers and academic economists have long been aware of the necessity of taking returns as well as risk into account: "all your eggs should not be placed in the same basket". This is where the idea of holding a portfolio of shares comes from. Modern portfolio theory (MPT), or portfolio theory, was introduced by Harry Markowitz with his paper "Portfolio Selection" which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection. Portfolio theory explores how risk averse investors construct portfolios in order to optimise expected returns for a given level of market risk. The theory quantifies the benefits of diversification. Out of a universe of risky assets, an efficient frontier of optimal portfolios can be constructed. Each portfolio on the efficient frontier offers the maximum possible expected return for a given level of risk. An example of this can be seen below.The Efficiency FrontierThe green region corresponds to the achievable risk-return space. For every point in that region, there will be at least one portfolio that can be constructed and has the risk and return corresponding to that point. The efficient frontier is the gold curve that runs along the top of the achievable region. Portfolios on the efficient frontier are optimal in both the sense that they offer maximal expected return for some given level of risk and minimal risk for some given level of expected return. Typically, the portfolios that comprise the efficient frontier are the ones that are most highly diversified. Less diversified portfolios tend to be closer to the middle of the achievable region. Investors should hold one of the optimal portfolios on the efficient frontier and adjust their total market risk by leveraging or deleveraging that portfolio with positions in the risk-free asset. Leveraging is any process that increases exposure to a source of risk. Based upon strong simplifying assumptions, a capital asset pricing model concludes that the market portfolio sits on the efficient frontier, and all investors should hold that portfolio, leveraged or deleveraged with positions in the risk-free asset. We also see the Capital Market line, which is the tangent to the efficiency frontier. This give the greatest expected return possible at every level of risk. As you can see, it gives a higher expected return than the frontier itself so rational investors will choose a portfolio on the Capital Market Line. The area below where this line connects with the expected return is the area where the return is risk free and the point where it intercepts the efficiency frontier will be the market portfolio, which is a portfolio consisting of every issue, weighted proportionally to the total market value of that issue outstanding in the market.Portfolio theory provides a broad context for understanding the interactions of...

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