The portfolio theory in minimizing the risk and maximizing the return

Essay by kalpurushUniversity, Master's March 2005

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Portfolio theory founded by Markowtz (1952) is a revolutionary theory changed finance profession from 'arts' to 'science'. It gives direction of how to minimize risk at a given return or maximize return at a given return. A portfolio is a bundle of assets with different levels of return and risk. The constituent assets are combined with relative weights. Portfolio theory studies how the characteristics (e.g. risk and return) of asset combination differ from those of its constituent assets. The term 'diversification' derived from the theory becomes standard strategy for investment circles. Risk in Finance is the uncertainty in the future, which means that there are different possible outcomes in the future. (1. Handout)

Finance basically deals with risk and expected return. Portfolio is one of the important factors of Finance. Certain amount of money invested in different assets like bond stocks or securities makes a portfolio of investments. This portfolio is about how can we reduce the risk and make better return through diversification.

We have to create our portfolio that should have the mixture of both risk free and risky assets. Risk free assets are the bonds issued by government and some financial institutions, like Treasury bills, some bonds certified by government and so on. On the other hand most of the bonds, stocks are considered as risky assets. Returns of the risky assets depend on economical situation. There may be 3 kinds of situation in the economy like recession, normal and boom. Risk free assets always give the same return in all the situation of economy. On the other hand risky assets give different rate of return in different economic situations. So in different types of situation we will get different types of return, then here comes the risk of the assets. So we have to deal...