Concept of portfolio

Portfolio theory was originally proposed by Harry M. Markowitz in 1952. The theory is concerned with the selection of an optimal portfolio by a risk-averse investor. A risk –averse investor is an investor who select a portfolio that maximizes the expected return for any given level of risk or minimizes the risk for any given level of expected return. Thus a risk-averse investor will select only efficient portfolios.

The selection of the optimal portfolio depends on the investors preferences for risk and returns. The investors risk-return preferences can be represented by indifference curves. By combining the efficient portfolios with the investor’s indifference curves. By combining the efficient portfolios with the investor’s indifferences curves, the optimal portfolio can be determined.

Portfolio theory assumptions

The portfolio model developed by Markowitz is based on the reasonable assumption:

• The expected return from asset is the mean value of a probability distribution of future returns over some holding period.
• The risk of an individual asset or portfolio is based on the variability of returns.
• Investors depend solely on their estimates of return and risk in making their investment decisions. This means that an investors utility is only a function of the expected return and risk.
• Investors adhere to the dominance principle. That is for any given level with a lower expected return; for assets with the same expected return, investors prefer lower to higher risk.