In the world of investments, one of the most important ideas is that of a portfolio. A portfolio simply refers to a mix of an investor’s investments in different asset classes such as equities, bonds, commodities and real estate.
We know that the maximum return an investor can earn is by investing all the money in a single asset. However, this approach is dangerous and poses high risk to your investment. Instead of investing everything in one asset investors prefer to put their money on different assets even though their overall returns may reduce. This is simply because of the benefits of diversification offered by a portfolio containing more number of assets.
Since most assets have a degree of correlation with each other that is less than 1, the risk from one asset cancels out the risk (atleast partially) from another asset and the overall risk reduces. Diversification reduces returns also, but the benefits in terms of risk reduction are much higher compared to the return reduction. We should also note that a portfolio approach does not necessarily provide downside protection or eliminate risk. It is however effective at reducing the level of risk (portfolio’s volatility).
While taking the portfolio perspective, another important point of importance is how we evaluate a new security that we are considering adding to the already existing security. The key idea is that we already have a portfolio with certain risk/return profile. Now when we bring in a new security we need to evaluate how it affects the risk-return profile of our portfolio. For example, how much additional risk the investment manager is taking for adding one additional unit of risk?
Another important point is about how risk is measured. Before 1950s, we did not have a way of quantifying the risk a person faced for his investment. We knew the returns we will get from our investments. We also intuitively knew that one investment was more risky compared to another. However, we didn’t have a way of quantifying the risk. Then in 1950s, Henry Markowitz proposed his framework where we could use standard deviation as a measure of risk. This was proposed in his article on portfolio selection which now forms the basis of Modern Portfolio Theory (MPT). The key idea of MPT is that investors should not just hold a portfolio but also pay attention to how the individual securities are related to one another.