The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CHAPTER 3

Portfolio Selection

Frank J. Fabozzi, Ph.D., CFA, CPA Professor in the Practice of Finance Yale School of Management

 

Harry M. Markowitz, Ph.D. Consultant

 

Petter N. Kolm, Ph.D. Director of the Mathematics in Finance M.S. Program and Clinical Associate Professor Courant Institute of Mathematical Sciences, New York University

 

Francis Gupta, Ph.D. Director, Index Research & Design Dow Jones Indexes

 

 

 

 

 

This chapter is an introduction to the theory of portfolio selection, which together with capital asset pricing theory provides the foundation and the building blocks for the management of portfolios. The goal of portfolio selection is the construction of portfolios that maximize expected returns consistent with individually acceptable levels of risk. Using both historical data and investor expectations of future returns, portfolio selection uses modeling techniques to quantify “expected portfolio returns” and “acceptable levels of portfolio risk” and provides methods to select an optimal portfolio.

The theory of portfolio selection presented in this chapter, often referred to as mean-variance portfolio analysis or simply mean-variance analysis, is a normative theory. A normative theory is one that describes a standard or norm of behavior that investors should pursue in constructing a portfolio rather than a prediction concerning actual behavior.

Asset pricing theory goes on to formalize the relationship that should exist between asset returns and risk ...