Mean-Variance Approach

Abstract

The mean-variance approach is the most widely used in the portfolio selections. The portfolio selection is based on two variables: (i) expected value of the portfolio return; (ii) variance of the expected portfolio return measuring the portfolio risk. An efficient portfolio must satisfy the Pareto optimal condition. Therefore, the investor prefers the portfolio that is capable of maximising its expected return to an equal variance or the portfolio capable of minimizing its variance to an equal expected return. This approach simplifies the problem of portfolio selection. There are two main advantages: first, it does not require specification about probability distribution; second, it is simple and intuitive because it is only based on the mean and variance. However, it is also true that this approach neglects a lot of relevant information about distribution probability. The entire portfolio selection process can be simplified on the basis of two main phases of the portfolio selection process: