Modern Portfolio Theory: Foundations, Analysis, and New Developments, + Website

Chapter 1

Introduction

The number of alternative investments is overwhelming. Thousands of stocks, thousands of bonds, and many other alternatives are worthy of consideration. The purpose of this book is to simplify the investor's choices by treating the countably infinite number of stocks, bonds, and other individual assets as components of portfolios. Portfolios are the objects of choice. The individual assets that go into a portfolio are inputs, but they are not the objects of choice on which an investor should focus. The investor should focus on the best possible portfolio that can be created.

Portfolio theory is not as revolutionary as it might seem. A portfolio is simply a list of assets. But managing a portfolio requires skills.

1.1 The Portfolio Management Process

The portfolio management process is executed in steps.

Step 1. Security analysis focuses on the probability distributions of returns from the various investment candidates (such as individual stocks and bonds).

Step 2. Portfolio analysis is the phase of portfolio management that delineates the optimum portfolio possibilities that can be constructed from the available investment opportunities.

Step 3. Portfolio selection deals with selecting the single best portfolio from the menu of desirable portfolios.

These three phases are discussed briefly below.

1.2 The Security Analyst's Job

Part of the security analyst's job is to forecast. The security analyst need not forecast a security's returns for many periods ...