Portfolio Theory
Build efficient portfolios using Markowitz mean-variance optimization. Understand the efficient frontier and the role of correlation. Portfolio theory provides the mathematical foundation for why diversification works and how investors can maximize returns for a given level of risk.
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Study Tips
- ✓Lower correlation means better diversification benefits
- ✓Two-asset portfolio math is exam-critical
- ✓The tangent portfolio is where CML touches the efficient frontier
- ✓Practice with a 2x2 covariance matrix
Common Mistakes to Avoid
Assuming equal-weighted portfolios are always optimal. The minimum variance portfolio often has unequal weights depending on risk and correlation. Also, students confuse the Capital Market Line (uses total risk) with the Security Market Line (uses beta).
Portfolio Theory FAQs
Common questions about portfolio theory
The set of portfolios that offer the highest expected return for each level of risk. No rational investor picks below the frontier because they could get more return for the same risk or less risk for the same return.
When assets are less than perfectly correlated, combining them reduces portfolio risk below the weighted average of individual risks. The lower the correlation, the greater the diversification benefit.
The CML is a line from the risk-free rate through the tangent (market) portfolio. All investors hold combinations of the risk-free asset and the market portfolio. The CML slope is the Sharpe ratio of the market portfolio.
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