Efficient Risky Portfolios

Abstract

Rather than investing in a single asset, most investors put their money into a portfolio of assets. This raises the question of how to calculate the expected return and risk of a portfolio. Furthermore, it has to be determined which portfolios of risky assets are most efficient in terms of expected return and risk. Markowitz’s portfolio theory demonstrates how to construct the efficient frontier on which the most efficient risky portfolios lie with regard to expected return and risk. The efficient frontier is created from capital market data, which are used to estimate the expected return and standard deviation of the returns of individual assets, as well as the covariance or correlation coefficient between the returns of a pair of assets. This chapter describes how to calculate the expected return and risk of a portfolio of risky assets. It then demonstrates how the efficient frontier can be determined using historical return data. The chapter ends with a discussion of the diversification effect and the number of stocks required for a well-diversified portfolio.