Portfolio Theory: Mean-Variance Analysis and the Asset Allocation Decision

In this chapter, we will explain a theory about how investors should construct a portfolio. The model for portfolio construction was developed in 1952 by Harry Markowitz and, despite being developed almost 70 years ago, is still referred to as modern portfolio theory. Because this theory for portfolio construction uses as inputs the mean and variance of portfolio returns, the theory is commonly referred to as mean-variance analysis. This framework for portfolio construction is one of the two principal theories in asset management. Prior to the development of mean-variance analysis, asset managers would often speak of risk and return but failed to quantify these important measures and apply them in portfolio construction. Moreover, asset managers would focus on the risks of individual assets without understanding how combining those into a portfolio could affect a portfolio’s risk. In the next chapter, an economic theory called the capital asset pricing model is explained and is the second principal theory in asset management. This theory, which provides the relationship between risk and expected return, is used to determine how assets should be priced in the market. It does so by estimating what return market participants should expect for an asset given its risk and how risk should in fact be measured…