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

SOME BASIC CONCEPTS

Portfolio theory draws on concepts from two fields: financial economic theory and probability and statistical theory. This section presents the concepts from financial economic theory used in portfolio theory. While many of the concepts presented here have a more technical or rigorous definition, the purpose is to keep the explanations simple and intuitive so that the reader can appreciate the importance and contribution of these concepts to the development of modern portfolio theory.

Utility Function and Indifference Curves

There are many situations where entities (i.e., individuals and firms) face two or more choices. The economic “theory of choice” uses the concept of a utility function to describe the way entities make decisions when faced with a set of choices. A utility function assigns a (numeric) value to all possible choices faced by the entity. The higher the value of a particular choice, the greater the utility derived from that choice. The choice that is selected is the one that results in the maximum utility given a set of constraints faced by the entity.

In portfolio theory too, entities are faced with a set of choices. Different portfolios have different levels of expected return and risk. Typically, the higher the level of expected return, the larger the risk. Entities are faced with the decision of choosing a portfolio from the set of all possible risk–return combinations, where when they like return, they dislike risk. Therefore, entities ...