ABSTRACT
This chapter presents a number of basic concepts and results of portfolio theory. The mean return on the portfolio depends only on the mean returns on the individual assets, the risk of the portfolio depends on the relationship between the asset returns, as measured by their correlation. This is a fundamental idea in portfolio theory; in particular, it plays an important role in the concept of diversification, which refers to reducing the risk of a portfolio by investing in many assets, a central idea in portfolio theory. The portfolios with negative weights are convenient from a mathematical point of view. The minimum-variance portfolio completely ignores the expected return of the portfolio. Investment in a risk-free asset might contribute only a small return to portfolio but it reduces the risk of the investment, giving the investor a convenient way to control risk. The Sharpe ratio has a useful interpretation as the expected excess return on the portfolio per unit of risk.
