idea advanced by H. Markowitz about a welldiversified portfolio. The central theme of the theory is that rational investors behave in a way that reflects their aversion to taking increased risk without being compensated by an adequate increase in expected return. Also, for any given expected return, most investors will prefer a lower risk, and for any given level of risk, they will prefer a higher return to a lower return. Markowitz showed how quadratic programming could be used to calculate a set of "efficient" portfolios. An investor then will choose among a set of efficient portfolios the best that is consistent with the risk profile of the investor.
sophisticated investment decision approach that permits an investor to classify, estimate, and control both the kind and the amount of expected risk and return; also called portfolio management theory or modern portfolio theory. Essential to portfolio theory are its quantification of the relationship between risk and return and the assumption that investors must be compensated for assuming risk.
more formally termed modern portfolio theory (MPT), a sophisticated investment decision approach that permits an investor to classify, estimate, and control both the kind and the amount of expected risk and return; also called portfolio management theory. Essential to portfolio theory are its quantification of the relationship between risk and return and the assumption that investors must be compensated for assuming risk. Portfolio theory departs from traditional security analysis in shifting emphasis from analyzing the characteristics of individual investments to determining the statistical relationships among the individual securities that comprise the overall portfolio. The portfolio theory approach has four basic steps: security valuation-describing a universe of assets in terms of expected return and expected risk; asset allocation decision-determining how assets are to be distributed among classes of investment, such as stocks or bonds; portfolio optimization-reconciling risk and return in selecting the securities to be included, such as determining which portfolio of stocks offers the best return for a given level of expected risk; and performance measurement-dividing each stock's performance (risk) into market-related (systematic) and industry/security-related (residual) classifications.
