Ch 14. Portfolio Theory and Diversification

“Can we increase returns while reducing risk?” In 1952, Harry Markowitz mathematically proved that by exploiting the correlations between assets, you can dramatically cut risk without sacrificing overall returns.

1. The Core of the Portfolio Effect

The expected return of a two-asset portfolio is simply the weighted average of each asset’s return. But the risk (standard deviation) of the portfolio will be lower than the sum of the individual risks — as long as the correlation between the two assets is less than 1.

2. Risk-Return Visualization

See the trajectory traced as you shift the allocation between stocks (high risk, high return) and bonds (low risk, low return).

3. The Efficient Frontier

In the simulation graph, the set of portfolios that offer the highest return for a given level of risk — or the lowest risk for a given level of return — forms what is called the Efficient Frontier. Any rational investor should only choose portfolios that sit on this frontier.

Diversification is often called the only free lunch in financial markets. Build a robust return map through disciplined, science-based asset allocation.