ABSTRACT

INTRODUCTION In this chapter, we will lay the foundations of portfolio theory, that is, we will see how an investor can construct the best possible (optimal) risky-asset portfolio. In doing that, we will examine the key concept of diversifi cation, which was laid out formally by Harry Markowitz in 1952 (recall that we briefl y examined his investment philosophy in Chapter 2). Then we discuss, from the conceptual and mathematical points of view the notions of correlation, covariance, and regression (with more illustrations in Appendices A and B). Next, we proceed with the construction of simple portfolios consisting of two risky assets and then augment them by including the risk-free asset. We will then see the differences in the risk /return outcomes from these two different portfolios. Finally, we conclude with some common diversifi cation fallacies that arise in the asset allocation step of the investment process (following the top-down approach to investing).