Home > Topics > Portfolio Management > Basic Principles of Portfolio Theory
← PreviousNext →

Basic Principles of Portfolio Theory ⚖️📚

Why do some investors succeed over decades while others lose money? Success in portfolio management isn't just about luck; it's about following a set of mathematical and logical rules. These are the Basic Principles of Portfolio Theory.

Loading stats…

1. The Risk-Return Tradeoff

The most fundamental law of finance is simple: To earn a higher return, you must be willing to accept higher risk.

  • Risk-Free Assets: (e.g., Treasury Bills) Offer low returns but provide high safety of capital.
  • Risky Assets: (e.g., Small-cap stocks) Offer potential for huge returns but carry the risk of losing half your money in a year.
Important

A rational investor will never take additional risk unless they are compensated with a higher expected return.

2. Maximizing Utility

Investors aren't just looking for "the most money." They are looking for the "most satisfaction" (Utility). Utility depends on two factors:

  1. Return: How much they earn (They want more).
  2. Risk: How much they worry (They want less).

A portfolio that gives an investor the perfect balance between profit and peace of mind is said to have the highest Utility.

3. The Dominance Principle

In a world of thousands of stocks, how do you choose? The Dominance Principle helps you narrow them down. An investment is "dominant" if:

  1. It offers the same return as another asset but with lower risk.
  2. It offers a higher return than another asset for the same level of risk.
PortfolioExpected ReturnRisk (SD)Status
A12%5%Dominant (Better than B)
B10%5%Dominated by A
C12%8%Dominated by A

4. Efficiency and Optimization

A portfolio is called Efficient if it is impossible to get a higher return without increasing risk.

  • Inefficient Portfolio: You are taking too much risk for the small return you are getting. You can improve this by diversifying.
  • Optimized Portfolio: You have reached the "best possible" version of that portfolio.

Loading comparison…

Summary

  • Every investment has a Risk-Return Tradeoff.
  • Utility is the balance between greed (return) and fear (risk).
  • The Dominance Principle filter out bad investment choices.
  • The goal is to move from an inefficient portfolio to an Efficient one.

Quiz Time! 🎯

Loading quiz…

← PreviousNext →