2185 Words9 Pages

“The Benefits of diversification are clear. Portfolio theory has played a crucial role in explaining the relationship between risk and return where more than one investment is held. It also enables us to identify optimal and efficient portfolios.”
With Reference to this statement, describe, discuss and illustrate the principles of portfolio theory. Your essay should include coverage of the Markowitz Efficient Frontier and the Capital Market Line.
Declaration:
I confirm that this submission is my own work.
Vinita Java
Introduction:
An investor would invest in a security for the return. However that return comes with a premium, the Risk. The higher the risk an investor is willing to take the higher the returns would*…show more content…*

He suggested that investors should choose portfolios and not individual shares.
(http://www.riskglossary.com/link/portfolio_theory.htm).
Portfolio Theory:
Markowitz contribution showed that the benefits of diversification depend not just on risking individual assets but also on how the asset returns interact with each other, or the correlation between returns.
E.g. A combination of investments in Umbrellas and Ice Creams will eliminate the risk of one another, i.e., the low returns from ice creams in rainy season will be compensated by the umbrella sales. High returns in one industry, in this case, always offset low returns in the other to give a positive return with certainty because returns on the two assets are inversely correlated.
Risk of a portfolio (combination of shares) depends on the correlation between the expected return of every pair of shares in a portfolio. Correlation varies between +1 and -1. Thus a perfectly positively correlated portfolio would mean a +1 and a negatively correlated portfolio would mean -1. In a positively correlated portfolio the expected return would move in the same direction in the same proportion at all times, however in a negatively correlated portfolio the returns would move in the opposite direction (J Ogilvie & B Koch 2002).
A change in any of the variables (proportions of the

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