Portfolio Theory

Abstract A portfolio is a collection of securities. Portfolio theory is a formal analysis of the relationship between the rates of return on a portfolio of risky securities and the rates of return on the securities contained in that portfolio. The rate of return on a portfolio is a random variable. The probability distribution that generates values for the rate of return on the portfolio is a compilation of the probability distributions that generate the rates of return on the securities contained in that portfolio. In this chapter, we develop an elementary version of portfolio theory. We then use that theory to explain how a rational investor would allocate funds among risky securities to create a portfolio that best suits his or her preferences regarding alternative combinations of risk and expected return.