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

KEY POINTS

• Markowitz quantified the concept of diversification through the statistical notion of the covariances between individual securities that make up a portfolio and the overall standard deviation of the portfolio.

• A basic assumption behind modern portfolio theory is that an investor’s preferences over portfolios with different expected returns and variances can be represented by a function (utility function).

• The basic principle underlying modern portfolio theory is that for a given level of expected return an investor would choose the portfolio with the minimum variance from amongst the set of all possible portfolios.

• Minimum variance portfolios are called mean-variance efficient portfolios. The set of all mean-variance efficient portfolios is called the efficient frontier. The portfolio on the efficient frontier with the smallest variance is called the global minimum variance portfolio (GMVP).

• The efficient frontier moves outwards and upwards as the number of (not perfectly correlated) securities increases. The efficient frontier shrinks as constraints are imposed upon the portfolio.

• Index models are used as an alternative to estimating the full variance-covariance structure of a set of securities

• The stable Paretian distribution has been proposed as an alternative to the normal distribution for modelling asset returns. This is because it is more consistent with two empirically observed behavior of asset returns: fat tails and asymmetry.

• In addition ...