Investments: Analysis and Management, 12th Edition

chapter 7

Portfolio Theory

Everyone keeps telling you that with $1 million to invest, you can have a nice portfolio of securities. And then the thought occurs: what is a portfolio exactly? You begin to wonder if a portfolio has characteristics you need to consider, because you can recall someone talking about portfolio theory, and what it means to investors. You have heard people say don't put all of your eggs in one basket, so how does that apply to investing? If you decide to put the entire $1 million in two stocks, what will the trustee say? It is not difficult to pick up a popular press article on investing and read about the importance of diversification, or hear about how some stocks seem to react negatively to threats of rising inflation while others seem to respond positively. Therefore, it seems like a good idea to expose yourself to at least the basics of portfolio theory. Then you will not be intimidated when someone starts talking about Markowitz portfolio theory, a universal concept in today's global investing world that is widely known and discussed.

In this chapter, we outline the nature of risk and return as it applies to making investment decisions. Unlike Chapter 6, we are talking about the future—which involves expected returns, and not the past—which involves realized returns. Investors must estimate and manage the returns and risk from their investments. They reduce risk to the extent possible without affecting returns by building diversified portfolios. Therefore, ...