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What is Portfolio?

The term portfolio refers to any combination of financial risk such as stocks, bonds and cash.
Portfolios may be held by individual investors and/or managed by financial professionals,
hedge funds, banks and other financial institutions. It is a generally accepted principle that a
portfolio is designed according to the investor's risk tolerance, time frame and investment
objectives. The monetary value of each asset may influence the risk/reward ratio of the
portfolio and is referred to as the asset allocation of the portfolio. When determining a proper
asset allocation one aims at maximizing the expected return and minimizing the risk. This is
an example of a multi-objective optimization problem: more "efficient solutions" are available
and the preferred solution must be selected by considering a trade-off between risk and return.

Types of Portfolios

Stocks: Also known as an equity or a share, a stock gives you a stake in a company and its
profits. Basically, to get partial ownership of a public company. A large percentage of our
portfolio should probably be made up of stocks.

Real Estate: Any real estate you buy and then rent out or resell is an ownership investment or
sometimes it is called alternative investment. By their terms, the home we own fulfils a basic
need, so it doesn't fall under this category.

Precious objects: Precious metals, art, collectables, etc. can be considered an ownership-type
of investment if the intention is to resell them for a profit.

Business: Putting money or time toward starting your own business, a product or service meant
to earn a profit is another type of ownership investment.

Markowitzs Portfolio Theory

Markowitzs Portfolio Theory which also known as Modern Portfolio Theory and its purpose
is to understand that how effectively allocate our investment portfolio. Harry Markowitz put
forward this model in 1952. It assists in the selection of the most efficient by analysing various
possible portfolios of the given securities. By choosing securities that do not 'move' exactly
together, the Markowitz model shows investors how to reduce their risk. This model is also
called mean-variance model due to the fact that it is based on expected returns (mean) and the
standard deviation (variance) of the various portfolios. Harry Markowitz made the following
assumptions while developing the model:
Risk of a portfolio is based on the variability of returns from the said portfolio.
An investor is risk averse.
An investor prefers to increase consumption.
The investor's utility function is convex and increasing, due to his risk aversion and
consumption preference.
Analysis is based on single period model of investment.
An investor either maximizes his portfolio return for a given level of risk or maximizes
his return for the minimum risk.
An investor is rational in nature.

To choose the best portfolio from a number of possible portfolios, each with different return
and risk, two separate decisions are to be made:
1. Determination of a set of efficient portfolios.
2. Selection of the best portfolio out of the efficient set.

Risk and Return

Financial risk can be defined as deviation away from expected historical returns during a
particular time period. However, Markowitz portfolio selection theory maintains that the
essential aspect pertaining to the risk of an asset is not the risk of each asset in isolation, but
the contribution of each asset to the risk of the aggregate portfolio.

Risk of a security can be analysed in two ways:

Stand Alone Basis: Asset is considered in isolation.

Portfolio Basis: Asset represents one of many assets.

In context of a portfolio, the total risk of a security can be divided into two basic components:
systematic risk also known as market risk or common risk and unsystematic risk also known
as diversifiable risk. Modern Portfolio Theory assumes that these two types of risk are common
to all portfolios.

Systematic Risk is a macro-level form of risk that affects a large number of assets to one
degree or another. General economic conditions, such as inflation, interest rates,
unemployment levels, exchange rates or Gross National Product-levels are all examples of
systematic risk factors. These types of economic conditions have an impact on virtually all
securities to some degree. Accordingly, systemic risk cannot be eliminated.
Unsystematic Risk on the other hand, is a micro-level form of risk factors that specifically
affect a single asset or narrow group of assets. It involves special risk that is unconnected to
other risks and only impacts certain securities or assets.

Unsystematic risk can be significantly reduced by the diversification of securities within a

portfolio. Since, in practice, the returns on different assets are correlated to at least some degree,
unsystematic risk can never truly be completely eliminated regardless of how many types of
assets are aggregated in a portfolio.


The objective of diversification is to maximize returns and minimize risk by investing in

different assets that would each react differently to the same event(s). The terms Diversification
or Diversification Effect refer to the relationship between correlations and portfolio risk.
Diversification, a cornerstone of Markowitz portfolio selection theory and MPT, is a risk
reduction concept that involves the allocation of investments among various financial
instruments, industries and other investment categories. In more simplistic terms, it relates to
the well-known adage dont put all your eggs in one basket. If the basket is dropped, all eggs
are broken; if placed in more than one basket, the risk that all eggs will be broken is
dramatically reduced. Diversification can be achieved by investing in different stocks, different
asset classes (e.g. bonds, real estate, etc.) and/or commodities such as gold or oil.

Efficient Frontier

Efficient Frontier, also referred to as Markowitz Efficient Frontier, is a key concept of Modern
Portfolio Theory. It represents the best combination of securities (those producing the
maximum expected return for a given risk level) within an investment portfolio. It describes
the relationship between expected portfolio returns and the riskiness or volatility of the

The relationship between securities within a portfolio is an important part of the Efficient
Frontier. For instance, the price of some securities in a portfolio moves in the same direction,
while the price in others moves in opposite directions. The greater the covariance (the more
they move in opposite), the smaller the standard deviation (the smaller the risk) within the