Dominance principles:

A portfolio manager who examines the expected rate of returns& risk statistics for many bonds & stocks may select assets worthy of investment by using a dominance principle Dominance principles are principle which provides some good idea to review what it means and how it applies to investment portfolio. The dominance principle states: Among investments with the same rate of return, the one with the least risk is most desirable. In addition, given a group of investments with the same level of risk, the one with the highest return is most desirable.

The most common case where this principle comes into play is when selecting investments in an employer based retirement plan like a 401k, 403b, or 457 plans. Usually, these plans will have multiple investment options in any given investment category. As an example, a 401k plan might have five large cap stock funds in its line up with each having similar long-term returns. To make things easy, let's consider a line up of imaginary funds as follows:
Portfolio

Large Cap Fund A Large Cap Fund B Large Cap Fund C Large Cap Fund D Large Cap Fund E

Return 10% 10% 10% 10% 10%

Risk/st.dev 19% 17% 21% 36% 28%

Here, all of the funds have the same return for the given time period. However, the standard deviation (a measure of risk) varies widely from 17% up to 36%. What this means is that while the rates of return are the same, the risk level of Large Cap Fund B is less than half that of Large Cap Fund D. Using the dominance principle, the most desirable fund in this lineup is Large Cap Fund B. Naive Diversification:
Naive Diversification means a portfolio consisting of stock chosen at random. Naive diversification rests on the assumption that simply investing in enough unrelated assets will reduce risk sufficiently to make a profit. Alternately, one may diversify naively by applying the capital asset pricing model incorrectly and finding the wrong efficient portfolio frontier. Such diversification does not necessarily decrease risk at a given expected return, and may in fact increase risk.

Markowitz Diversification:
It is diversification of combining assets that are less than perfectly positively correlated in order to reduce portfolio risk without sacrificing portfolio returns. It is more analytical than simple diversification and considers assets correlations. The lower the correlation among assets, the more will be risk reduction through Markowitz diversification

Efficient Frontier & Feasible set: Efficient Frontier:

Efficient Frontier is the locus of points in risk-return space having the maximum return at each risk level or the least possible risk at each level of desired return. It presents a set of portfolios that have the maximum return for every given level of risk or the minimum risk for a given level of return. An investor target a point along the efficient frontier based on his utility function and attitude towards risk. It shows that can a portfolio on the efficient frontier dominate any other portfolio on the efficient frontier?

Feasible set:
Grouping of every efficient portfolio graphically represented with the Markowitz efficient frontier, giving the collative group that matches a specific risk return requirement. Graphically these are summarised by the minimum variance- frontier of risky assets. Each point along the minimum variance frontier represents the lowest possible variance that can be attained for a given portfolios expected return.

A portfolio that gives maximum return for a given risk, or minimum risk for given return is an efficient portfolio. Thus, portfolios are selected as follows: (a) From the portfolios that have the same return, the investor will prefer the portfolio with lower risk, and (b) From the portfolios that have the same risk level, an investor will prefer the portfolio with higher rate of return.

The boundary PQVW is called the Efficient Frontier. All portfolios that lie below the Efficient Frontier are not good enough because the return would be lower for the given risk. Portfolios that lie to the right of the Efficient Frontier would not be good enough, as there is higher risk for a given rate of return. All portfolios lying on the boundary of PQVW are called Efficient Portfolios. The Efficient Frontier is the same for all investors, as all investors want maximum return with the lowest possible risk and they are risk averse.

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