Mastering Investment 2001 / Part Four

Insights from portfolio theory
By Raman Uppal
Published: June 1 2001 12:07GMT | Last Updated: June 1 2001 16:29GMT

Raman Uppal is an associate professor of finance at London Business School.

Various theories have established the importance of portfolio diversification to reduce and the capital asset pricing model provides a way to measure expected returns for any publicly quoted company. The main results of modern portfolio theory are:

• Diversification reduces risk.

• Variances of individual assets contribute little to portfolio risk.

• Correlations between assets determine the risk of a portfolio.

• Investors hold frontier portfolios; a large asset base improves the portfolio frontier.

• When there is risk-free asset, frontier portfolios are linear combinations of the risk-free asset and the tangency portfolio.

• In equilibrium, the tangency portfolio is the equal to the market portfolio.

• Over several different investment periods, the optimal portfolio has two components: the first is one that is optimal for a single period investor and lies on the efficient frontier, and the second component is one that provides the best hedge against future changes in the efficiency frontier.

These insights underlie the investment strategies of individuals and financial institutions. The gains from diversification motivate investors and mutual funds to hold a broad range of equities. Index funds, which track the market portfolio, are designed to make it convenient for investors to invest in a large number of equities.

The understanding that it is systematic rather than the unsystematic risk of a security that matters, and that systematic risk is measured by the correlation of the security with the market, leads to the beta measure. This is widely used to determine the appropriate return a stock must offer investors.

Finally, the extension of the portfolio model to account for investment over more than one trading horizon is now being used to design dynamic portfolio strategies