Portfolio Management covers portfolio theory, the Capital Asset Pricing Model (CAPM), portfolio construction, risk management, and behavioral finance. This topic ties together concepts from across the curriculum into a unified investment framework.
MPT, developed by Harry Markowitz, demonstrates that portfolio risk depends not only on individual asset risks but also on the correlations between assets. Diversification reduces portfolio risk when assets are not perfectly correlated. The efficient frontier represents the set of portfolios offering the highest expected return for each level of risk. The minimum variance portfolio has the lowest risk on the efficient frontier. Adding the risk-free asset creates the Capital Market Line (CML), where the optimal risky portfolio is the tangency portfolio.
CAPM establishes that the expected return of an asset depends on its systematic risk (beta), not total risk. E(Ri) = Rf + βi(E(Rm) - Rf). The Security Market Line (SML) plots expected return against beta. Assets above the SML are undervalued (positive alpha); assets below are overvalued (negative alpha). Beta measures sensitivity to market movements: β > 1 means more volatile than the market; β < 1 means less volatile. CAPM assumes investors are rational, markets are efficient, and there are no taxes or transaction costs.
Total risk = Systematic risk + Unsystematic risk. Systematic risk (market risk) cannot be diversified away and is measured by beta. Unsystematic risk (firm-specific) can be eliminated through diversification. Key performance measures: Sharpe ratio = (Rp - Rf)/σp (reward per unit of total risk); Treynor ratio = (Rp - Rf)/βp (reward per unit of systematic risk); Jensen's alpha = Rp - [Rf + βp(Rm - Rf)] (excess return above CAPM prediction).
The investment policy statement (IPS) defines the investor's objectives (return and risk) and constraints (time horizon, liquidity, taxes, legal, unique circumstances). Strategic asset allocation sets long-term target weights based on the IPS. Tactical asset allocation involves short-term deviations from strategic weights to exploit market opportunities. Rebalancing returns the portfolio to target weights — calendar rebalancing at fixed intervals or percentage-of-portfolio rebalancing when weights drift beyond tolerance bands.
Behavioral finance studies how psychological biases affect investment decisions. Cognitive biases include: anchoring (over-relying on initial information), confirmation bias (seeking information that confirms existing beliefs), overconfidence (overestimating one's abilities), and representativeness (judging probability by similarity). Emotional biases include: loss aversion (feeling losses more strongly than equivalent gains), status quo bias (preferring the current state), and endowment effect (overvaluing what one owns). These biases can lead to suboptimal investment decisions.
Weighted average of individual asset expected returns.
Portfolio risk depends on individual risks, weights, and correlation.
Expected return based on systematic risk (beta) and the market risk premium.
Risk-adjusted return measure using total risk (standard deviation).
Excess return above what CAPM predicts. Positive alpha indicates outperformance.
Measures systematic risk — sensitivity of asset returns to market returns.
The IPS is the foundation of the portfolio management process.
The Capital Asset Pricing Model relates expected return to systematic risk.